By Yuriy Smirnov Ph.D.

Current ratio refers to a liquidity ratio that measures the ability of a business to meet its short-term obligations. The current ratio shows the number of times current assets cover current liabilities of a business. In other words, it reflects the ability of a business to convert its current assets into cash without a loss in value to meet short-term obligations due within 12 months.

The formula of current ratio calculation is rather straightforward. It is expressed as follows:

Current Ratio = | Current Assets |

Current Liabilities |

Current assets are assets that are expected to be converted into cash within the next 12 months or within the operating cycle. Common examples of current assets:

- cash
- cash equivalents
- marketable securities
- investments
- trade receivables
- other receivables
- prepaid expenses
- inventory
- current tax assets
- derivative financial assets

Current liabilities are short-term obligations of a business that mature within the next 12 months. Common examples of current liabilities:

- short-term borrowings
- current portion of long-term borrowings
- trade payables
- other payables
- unearned revenues
- accrued expenses
- current tax liabilities
- derivative financial liabilities

The balance sheet of XYZ company is as follows:

Balance sheet, US$ in thousands

Let’s apply available data to the formula above.

Current Ratio _{20X7} = |
$15,650,000 | = 2.604 |

$6,010,000 |

Current Ratio _{20X8} = |
$14,610,000 | = 2.349 |

$6,220,000 |

The current ratio of XYZ company in the prior year was 2.604 and in the current year is 2.349. Its current year value of 2.349 compared with the baseline of 2.604 indicates a reduction in the company’s ability to service its obligations due in the next 12 months.

Generally, a higher number of current ratio is preferred because it indicates that a business has a strong ability to meet its short-term obligations. Some academic studies consider a range between 1.5 and 2 as acceptable liquidity.

One of the important points of analysis is the composition of current assets. For instance, two companies have an equal current ratio of 1.725, but one company has a greater proportion of slow-moving inventory in its current assets than the other. Formally, both of them have equal liquidity, but we should realize that the company with a lower proportion of slow-moving inventory is better able to meet its short-term obligations. Thus, everything else being equal investors and creditors would prefer the company with a lower proportion of slow-moving inventory.

Another key point of current ratio analysis is the industry average comparison. It helps to understand whether or not a company’s liquidity is better than average in the industry. Let’s consider the example above and assume the industry average in the current year is 1.975.

The current ratio of 2.349 stayed higher than the industry baseline of 1.975, which indicates a favorable ability of a company to service its short-term obligations.

You can also calculate the current ratio using our online calculator.

© 2018 FinancialManagementPro.com. All rights reserved.