Definition of Current Ratio
The current ratio is a financial ratio that shows the proportion of a company’s current assets to its current liabilities. The current ratio is often classified as a liquidity ratio and a larger current ratio is better than a smaller one. However, a company’s liquidity is dependent on converting the current assets to cash in time to pay its obligations.
Example of Current Ratio
If a company’s current assets are $600,000 and its current liabilities are $200,000 the current ratio is 3:1. If the current assets are $600,000 and the current liabilities are $500,000 the current ratio is 1.2:1. Obviously a larger current ratio is better than a smaller ratio. Some people feel that a current ratio that is less than 1:1 indicates insolvency. However, some online sellers with customers paying with credit cards at the time of ordering may operate comfortably with a very low current ratio.
It is wise to compare a company’s current ratio to that of other companies in the same industry. You are also wise to compare a company’s recent current ratio to its ratio at earlier dates. In other words, spotting a trend can be important.
Caution
The composition of the current assets is also an important consideration. If the current assets are predominantly in cash, marketable securities, and collectible accounts receivable, that is likely to provide more liquidity than a huge amount of slow moving inventory.
