The current ratio is a unique measure of the company’s solvency, the ability to repay the current obligations. Lenders widely use this ratio to assess the organization’s current financial position and the risk of issuing short-term loans.
The ratio is in line with the industry average and may also be slightly higher. Such values are considered acceptable. If these values are lower than the industry average, this may indicate higher default risks. The value has this name because the ratio includes all current assets, current liabilities (they include taxes payable).
How to calculate the current ratio
The current ratio is calculated as the proportion of existing assets to short-term liabilities is equal to:
current ratio = current assets/current liabilities.
Current assets listed on a company’s balance sheet include
Cash, accounts receivable, and numerous current assets are part of current assets. The calculation is done according to the balance: the numerator of the formula is taken from the asset of the balance sheet, the denominator — from the liability. Other liquidity ratios may complement the current ratio analysis. All resulting differences in numbers can help a person understand the current state of assets.
Current coefficient features
The current liquidity ratio can characterize a company’s ability to pay current or short-term liabilities with current or short-term assets. For instance, this could be money, inventory, and receivables.
If a company has a current ratio of less than 1.00, it often does not have the funds to meet its short-term obligations. On the other hand, a model of more than 1.00 may indicate that the company has the financial ability to pay. Nevertheless, it is worth remembering that this value cannot be considered a complete representation of a company’s short-term liquidity or long-term solvency.
For example, a company may have a high coefficient. However, its receivables may be very outdated. Perhaps the reason is customers’ slow payments. It may be hidden in the ratio. There might be a chance that part of the receivables will have to be written off in such a case. It is worth considering the quality of its other assets compared to its liabilities.
Common value
The higher the current ratio value is, the higher the liquidity of the company’s assets is evaluated. Typical and often optimal is a coefficient value of 2 or more. Nevertheless, in world practice, it is allowed to reduce the indicator for some industries to 1.5.
The coefficient value below the norm (below 1) indicates the likely difficulties in repaying the organization’s current liabilities. Nevertheless, to complete the picture, you need to look at the cash flow from the organization’s operations. Often, a low ratio is justified by a strong cash flow (for instance, in fast food chains retail).
The too-high current ratio is disfavored since it may reflect insufficiently efficient use of existing assets or short-term financing. In any case, lenders prefer to see a higher ratio as a sign of a company’s soundness.
Existing liquidity characteristics
Estimated liquidity characteristics of a legal entity reflect its ability to pay off existing current debts at the expense of its property and are the preeminent numerical indicators of its solvency, allowing it to be assessed over time. The latter, in turn, is determined by the speed of the sale of property constituting current assets at the disposal of the legal entity. The rate of sale of assets can be:
- High: concerning property that does not need to be sold (money) and will be sold quickly enough (cash equivalents, for example, highly liquid debt securities).
- Fast: for a property that requires some time for sale, but in general quick (short-term debt of debtors).
- Medium: for a property that will not be sold quickly and may lose part of its value during the sale (stocks, work in progress may be difficult to sell).
What does current liquidity show?
The indicator of current liquidity shows in what part the existing assets available to the legal entity, when sold at a market price, will cover its short-term liabilities. Concerning time, the coefficient reflects the level of solvency of a legal entity in a period not exceeding one year.
They take information to determine the current liquidity ratio from the enterprise’s balance sheet, compiled on any reporting dates. Usually, this is the annual balance sheet, but interim reporting can also be used. To see the nature of the change in this indicator over several periods, make several definitions of it for different reporting dates.
Restrictions on the current ratio usage
One limitation arises when using the current ratio to compare different companies’ information. It is vital to remember that all businesses differ in industry. Consequently, this will not be correct when comparing the current ratio of different companies from different areas. Insufficient specificity of the dermal agent is one of the primary drawbacks. Unlike numerous other liquidity ratios, it includes all its current assets, even those that cannot be readily liquidated.