Business, Legal & Accounting Glossary
The current ratio is an indication of a firm’s market liquidity and ability to meet short-term debt obligations. Acceptable current ratios vary from industry to industry. If a company’s current assets are in this range, then it is generally considered to have good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently utilizing its current assets.
Current Ratio is a financial metric which indicates a company’s ability to meet short-term debt obligations.
A high Current Ratio figure implies short term financial strength/liquidity.
Current Ratio is also known as Working Capital Ratio.
The current ratio is a balance-sheet financial performance measure of company liquidity.
The current ratio is calculated by dividing current assets by current liabilities. A current ratio of more than 1.0 means that a company’s short term assets exceed its short term liabilities. For example, if Tractorco has current assets of $12 million and current liabilities of $10 million then the current ratio for Tractorco is 1.20 or 1.2x. Although a current ratio of 2.0 or 2x means that a company has great short term financial strength, a current ratio of less than 1.0 does not necessarily signal problems unless this weak current ratio shows a persistent inability of a company to meet short term obligations. The current ratio is often calculated in conjunction with a second ratio, the “quick ratio” which subtracts inventories from current assets before dividing by current liabilities. Both quick ratio and current ratio “normal” measures vary greatly by industry and a comparison of current ratio with other companies within the same industry or sector is helpful in determining an investment’s current ratio quality.
All other things being equal, creditors consider a high current ratio to be better than a low current ratio because a high current ratio means that the company is more likely to meet its liabilities which are due over the next 12 months. Low values for the current ratio (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, an investor should also take note of a company’s operating cash flow in order to get a better sense of its liquidity. A low current ratio can often be supported by strong operating cash flow.
The higher the ratio, the more liquid the company is. A Current Ratio of 2 is generally acceptable, but this figure can vary from industry to industry. For example, a current ratio of 1.5 may be considered acceptable for industrial companies.
If the current ratio is too high (much more than 2), then the company may not be using its current assets or its short-term financing facilities efficiently. This may also indicate problems in working capital management.
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This glossary post was last updated: 19th April, 2020 | 8 Views.