What Is Current Ratio?
Current ratio or working ratio is the ability of a business to pay its short-term obligations that are due within a year. It measures the business' current assets against current liabilities. It is that liquidity ratio which gives investors and analysts an idea about the company's financial health– how it can maximize its current assets to meet its current debts and payables.
Formula: How To Calculate Current Ratio
The following formula calculates the current ratio:
Current Ratio= Current Assets/Current Liabilities
What Are Current Assets?
Current Assets are the resources that can readily convert to liquid cash within a year. It includes:
- Cash- petty cash, legal tender bills, checking and savings account, coins
- Cash equivalents- corporate or government securities with a maturity of 90 days or less
- Marketable securities- common stock, preferred stock, government and corporate bonds with maturity or one year or less
- Accounts receivable- money due within a year by customers to the company
- Inventory- raw materials, finished goods, work-in-progress
- Prepaid expenses- unexpired insurance premiums, advance payments
What Are Current Liabilities?
Current liabilities are financial obligations and other payments due to suppliers and creditors within a year. It includes:
- Accounts payable- credits earned by purchasing raw materials, supplies, merchandise, etc.
- Notes payable- loans that are coming due in a year to have interest and principal paid
- Deferred revenue- the payments earned in advance by the company for earnings that will happen once revenue recognition requirements are satisfied.
- Accrued expenses- Due income and payroll taxes, interest payable, and every accrued expense made without receiving an invoice
Example To Understand Current Ratio:
To understand with an example, let's calculate the current Ratio of Apple Inc. for the fiscal year 2017 using the current ratio formula discussed above. As given in their balance sheet:
Total Current Assets= $128.65 billion
Total Current Liabilities= $100.81 billion
Thus,
Current Ratio= 128.65/100.81=1.28
This result suggests that Apple had enough resources to meet its liabilities, indicating good financial health.
Current Ratio vs. Other Liquidity Ratios
Other comparable liquidity ratios can also be used to find numbers that the current ratio analysis gives us. An investor can learn more about the current state of the company's assets and liabilities by understanding how these metrics evolve over time and differ in each scenario.
The most commonly used among these is the acid-test ratio. It contrasts a company's current obligations with its quickly liquidated assets, excluding inventories and prepaid expenses. Similarly, the cash-asset ratio, or cash ratio, simply evaluates a company's cash and marketable holdings in relation to its current liabilities. Another metric, the operational cash flow ratio, compares the company's active cash flow from operating activities (CFO) to its current liabilities.
Investors, creditors, and suppliers make decisions based on their understanding of the current ratio. Thus, the current ratio is crucial for determining whether a company's interest is viable.
Significance Of Current Ratio
The current ratio proves to be a very effective financial tool in measuring a firm's liquidity. Here are a few significant benefits of using the current ratio:
- The current ratio helps determine the immediate financial standing of a company.
- It also assesses the ability of the firm to manage its creditors.
- The current ratio helps a company understand the working capital needs.
- The higher the ratio is, the higher the liquidity of the firm and the better the stability.
- This ratio also determines the operating cycle and its sales-generating capability.
- The current ratio can help you optimize your overhead expenses and better plan inventory storage.
- The current ratio can also help you make important investment-related decisions.
Limitations Of Current Ratio
Among the many advantages of using the current ratio, you will have to be careful about the following drawbacks that this tool brings. Listed below are a few of them you are likely to come across.
- There needs to be more than the current ratio to determine the liquidity accurately.
- This ratio measures only the quantitative aspects while neglecting the qualitative elements of current assets.
- It is also not a very accurate measure of a company's financial health since it doesn't account for obsolete produce or sale frequency.
- One might be able to observe a discrepancy in the ratio of companies that have seasonal sales.
- The ratio is also easily affected by a change in the method of inventory valuation.
- It is relatively easy to manipulate the current ratio, so it does not always provide a hundred percent accurate
What Is A Good Current Ratio?
The definition of a "good" current ratio is totally dependent on the environment of the sector in which a company's analysis takes place. For instance, retail businesses often have a high current ratio, whereas service sector businesses typically have low ratios.
A current ratio of less than 1 typically means that the company may only go bankrupt within a year if it grows its current cash flow to meet liabilities. On the other hand, a ratio of 1 can be seen as safe because it does not indicate any significant liquidity-related issues. Hence, a current ratio of more than 1 is generally preferable. The current ratio, however, is typically not an accurate picture of a company's short-term liquidity or longer-term solvency because it is only a snapshot at any given time.
Conclusion
In conclusion, the current ratio accurately indicates a firm's liquidity when combined with other strong financial indicators. Additionally, it makes it possible for investors, stockholders, and business owners to assess the company's financial situation and near-term prospects accurately. However, liquidity ratios alone should not be used to determine whether or not to invest in a company, and one should consider a person's age, income, capacity for danger, and financial objectives.