Definition
The Current Ratio is a liquidity ratio that measures a company’s ability to cover its short-term obligations with its short-term assets. It is calculated by dividing a company’s current assets by its current liabilities. A higher current ratio indicates greater short-term financial health.
Key Takeaways
- The Current Ratio is a liquidity ratio that measures a company’s ability to pay short-term and long-term obligations. A higher Current Ratio indicates a greater capability of the company to meet its obligations.
- The Current Ratio is calculated by dividing a company’s total current assets by its total current liabilities. It gives investors and analysts an idea of how well a company can convert its assets into cash in the short term.
- While a general rule of thumb is to have a Current Ratio of at least 1.0, different industries have different standards. A Current Ratio significantly lower than 1 may indicate liquidity issues, while a very high Current Ratio can indicate that a company is not using its current assets efficiently to grow its business.
Importance
The Current Ratio is a crucial financial metric as it indicates a company’s ability to cover its short-term liabilities with its short-term assets.
This liquidity ratio provides insights into a company’s operational efficiency and short-term financial health.
If the ratio is high, it suggests that the company is well-positioned to pay off its short-term debts as they become due.
Conversely, a low current ratio may suggest problems with liquidity, possibly leading to financial difficulties if the company cannot meet its short-term obligations.
Therefore, understanding the Current Ratio can enable more informed decision-making for investors, creditors, and internal management.
Explanation
The Current Ratio is primarily used in financial analysis to evaluate a company’s liquidity position, that is, its ability to meet short-term obligations. It provides insight into a company’s operational efficiency and its short-term financial health.
If a company has a high Current Ratio, it suggests that it has sufficient resources to pay its debts and meet its financial obligations that are due within a year. In using the Current Ratio, we can make comparative evaluations of a company’s liquidity over different periods.
A rising ratio could signal that the company is improving its liquidity and is safer from a creditor’s perspective. On the other hand, a falling ratio might be a cause for concern as it could indicate deteriorating financial health.
Additionally, the Current Ratio can also be used to compare the liquidity of different companies within the same industry, revealing the most financially stable and efficient ones. Therefore, it’s an invaluable tool for investors, creditors, and analysts alike.
Examples of Current Ratio
Walmart Inc.: As per the 2020 fiscal year report, Walmart had total current assets of approximately $90 billion and total current liabilities of approximately $80 billion. Therefore, its current ratio would be $90 billion / $80 billion, equals approximatelyThis suggests that Walmart can easily cover its short-term liabilities with its short-term assets.
Apple Inc.: According to its September 2020 quarter report, Apple reported $71 billion in current assets and $71 billion in current liabilities. This sets the company’s current ratio at36 ($71 billion / $71 billion), which indicates that Apple has more than enough resources to cover its short-term obligations.
Tesla Inc.: Tesla in its 2020 report had $62 billion in current assets and $52 billion in current liabilities. Therefore, Tesla’s current ratio was approximately69 ($62 billion / $52 billion). In Tesla’s case, a higher ratio further reassures investors that current liabilities could be paid off even if there was a decrease in current assets.
FAQs on Current Ratio
What is Current Ratio?
The current ratio is a liquidity ratio that measures a company’s ability to pay off its short-term liabilities with its short-term assets. It is calculated by dividing the company’s current assets by its current liabilities.
How is Current Ratio calculated?
The current ratio is calculated by dividing the total current assets of a company by its total current liabilities. Current assets include cash, accounts receivable, inventory, and other assets that are expected to be liquidated or turned into cash in a year or less. Current liabilities include accounts payable, accrued liabilities, and other short-term debt.
What does a high Current Ratio indicate?
A high current ratio generally suggests that a company is in a good financial health and has enough resources to pay its debts over the next 12 months. However, a very high ratio may also indicate that the company is not effectively using its assets to generate revenue.
What does a low Current Ratio indicate?
A low current ratio could be a sign that the company is struggling to maintain liquidity and might have trouble paying off its debts. However, certain industries naturally have a lower current ratio than others and in these cases, it might be more effective to compare a company’s current ratio to the industry average.
What is a good Current Ratio?
A good current ratio can vary by industry, but generally, a ratio of 1.5 to 2 is considered healthy. This means that for every dollar in current liabilities, the company has at least $1.50 to $2 in current assets. However, what is considered a “good” ratio can vary significantly by industry.
Related Entrepreneurship Terms
- Current Assets
- Current Liabilities
- Liquidity Ratios
- Working Capital
- Quick Ratio
Sources for More Information
- Investopedia: An extensive online dictionary of financial terms.
- The Balance: A website offering expert advice on all aspects of personal finance.
- NASDAQ: The official website covering financial and investment news.
- Yahoo Finance: A website providing financial news, data and commentary including stock quotes, press releases, financial reports, and original content.
