Current ratio

Definition

The current ratio is a financial metric that measures a company's ability to cover its short-term liabilities with its short-term assets. A higher current ratio indicates greater liquidity, meaning the business is more capable of meeting its obligations as they come due. This ratio is crucial in evaluating a company's financial health, particularly in assessing operational efficiency and risk management.

5 Must Know Facts For Your Next Test

1. The formula for calculating the current ratio is: $$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$.
2. A current ratio of less than 1 indicates that a company may struggle to meet its short-term obligations, which could signal financial distress.
3. A current ratio between 1 and 2 is generally considered healthy, showing that a company has enough assets to cover its liabilities.
4. Different industries have varying benchmarks for a healthy current ratio; thus, comparisons should be made within the same industry.
5. Investors and creditors often use the current ratio as part of their analysis to gauge the risk associated with lending money or investing in a company.

Review Questions

• How does the current ratio reflect a company's financial health and operational efficiency?
  • The current ratio serves as an indicator of a company's financial health by measuring its ability to pay off short-term liabilities with its short-term assets. A higher current ratio suggests that the company is in a good position to cover its obligations, reflecting operational efficiency in asset management. Conversely, a low current ratio could point to potential liquidity issues, indicating that the company might face challenges in meeting its short-term debts.
• What factors can influence changes in a company's current ratio over time, and why is it important for stakeholders to monitor these changes?
  • Several factors can influence a company's current ratio, including fluctuations in sales revenue, changes in inventory levels, and shifts in accounts receivable and payable. For instance, an increase in sales might lead to higher accounts receivable and inventory, improving the current ratio. Stakeholders must monitor these changes because they provide insights into the company's operational stability and liquidity risk, helping them make informed decisions about investments or lending.
• Evaluate how the current ratio can differ across industries and what implications this has for investors analyzing companies from different sectors.
  • The current ratio can vary significantly across industries due to differing business models and operational cycles. For example, a retail company may have a lower current ratio due to high inventory turnover rates compared to a manufacturing firm with substantial raw material inventories. Investors need to consider these industry-specific benchmarks when evaluating companies; a seemingly low current ratio in one sector may be acceptable or even healthy in another. Understanding these dynamics helps investors assess risk accurately and make better investment choices.

Related terms

liquidity: Liquidity refers to how easily an asset can be converted into cash without affecting its market price.

current assets: Current assets are assets that are expected to be converted into cash or used up within one year, such as cash, accounts receivable, and inventory.

current liabilities: Current liabilities are obligations a company needs to settle within one year, including accounts payable, short-term debt, and accrued expenses.