The Current Ratio is a useful financial formula within the family of Liquidity Ratios. It juxtaposes a company’s current assets and current obligations. This produces a number that reflects whether a business is able to cover its short-term debt with its current assets.
The Current Ratio Formula:
Current Ratio = Current Assets / Current Obligations
Current assets: These are a company’s assets that are expected to be used or sold within one calendar year. Current assets can include cash, cash equivalents, accounts receivable, inventory, and prepaid expenses, among other liquid assets.
Current obligations: Also called Current liabilities, these are a company’s short-term financial obligations, due within one calendar year. Current liabilities can include accounts payable, short-term debt, dividends, and taxes owed, among other financial obligations.
What can the Current Ratio tell me about my business?
If the current ratio produces a number higher than 1, that indicates your business is expected to have more assets coming in over the next year than payments and liabilities going out. If it is under 1, then your business has more current obligations than current assets.
The current ratio is an industry standard measure of liquidity. You can compare your current ratio to the current ratios of competitors and peers in your industry in order to establish whether you are within a healthy range.
Under this range (or worse, under 1) indicates a less stable financial position, which may be a warning that you’ll have difficulty paying outstanding debts. If you are much higher than your industry average, it can be indicative of an inefficient use of company assets.
The current ratio is also one of the ratios used by lenders to decide whether or not to extend credit or loans to a business. A higher current ratio means your company is in a more stable financial position, and therefore a lender is more likely to approve additional funding.