The current ratio Formula is essential for Financial Investors, creditors, and business owners. It’s important to calculate financial ratios.
The Current Ratio is the financial metric formula that measures a company’s specification to meet its short-term obligations. This is calculated by dividing the company’s current assets and current liabilities.
The Current assets are converted into cash within one year, while the current liabilities are obligations within one year.
A company’s financial health needs to be revealed. So, the company can cover its liabilities using current assets as fast as possible.
The higher current ratio has shown that the company has more current assets to cover its liabilities. The low current ratio has shown that the company may have struggled to meet its short-term obligations.
What is the Current Ratio?
The Current ratio is also known as the current balance, unlike other liquidity ratios. That cooperates with current assets and current liabilities.
The Current Assets include Cash, Cash Equivalents, Inventory, Prepaid Expenses, and Accounts Receivable. That’s converted into cash within one year.
The Current Liabilities include Short-term debt, Deferred revenue, Accrued expenses, and Accounts payable.
Accounts payable are amounts that are used by vendors or suppliers to receive goods or services. All total paid amounts are noted on the company’s Balance sheet.
Deferred revenue refers to advance payments to receive the products or services. That product or service must be delivered in the future.
How to Calculate the Current Ratio?
You can easily calculate the current ratio, by simply dividing the company’s current assets and its current liabilities. For example, the company has current assets of $10,00,000 and current liabilities take $5,00,000. The current ratio has been calculated as 2.0.
Interpretation of the Current Ratio
A current Ratio of 2.0 or higher can be considered as good. It means the company has twofold current assets than their current liabilities. That is good current assets to receive its short-term obligations.
In the below ratio of 2.0, the company may have struggled to receive its short obligations using its current assets. It means the company has faced unexpected problems.
Additionally, some companies like large retailers may have negotiated with suppliers for longer or average periods of payment. The company can notice this on the balance sheet as a highly payable balance.
Larger retailers can also reduce the inventory volume through an efficient supply chain. That helps to maintain the current ratio against current liabilities.
What factors affect the Current ratio?
You will see some factors that can affect the company’s current ratio such as
Industry – Some industries like retail and hospitality have lower current ratios than others such as the technology industry or manufacturing industry.
Small Company – Small companies can have a lesser current ratio compared to large companies.
Business model – Some business models like online e-commerce businesses have a lesser current ratio as compared to traditional businesses.
How to improve the Current Ratio?
The company can have improved the current ratio by working in some ways including:
Reduce inventory levels – Higher inventory can be considered as average cash. That also has been considered as the company having a lower current ratio. Companies can improve their current ratio by modifying their inventory management systems and providing some discounts on slow-moving items.
Accumulate Accounts Receivable – Accounts Receivable is also the part of current ratio to be calculated, Companies can accumulate more accounts receivable by providing discount offers for early payment and implementing strict policy services.
Increase the short–term debt – This term is included in the current liability. That can help to increase the current assets. It’s important to have used short-term debt carefully. A company’s debt can create the risk of bankruptcy.
How does the current ratio change over time?
The most of time, The current ratio good or bad depends on its changing. The company could have the following trending situation, whether they have a good current ratio, while they can avoid paying the bill payments.
Here, the company can go further to make a good current ratio. In this case, the current ratio over time change could be harmful to the financial company valuation. The improvement of the current ratio allows investing in undervalued stocks.
FAQ
There are two important things to consider for calculating the current ratio such as current assets and current liabilities.
Current Ratio = Current Assets / Current Liabilities
The current ratio of 2.0 or higher can be considered good. You can read this article, which will help you to understand about this topic.
The Current ratio of 2:1 indicates that the company’s assets are higher than the current liabilities. It means the company has good current assets and fewer current liabilities.
The current ratio percentage is calculated by dividing the company’s total current assets and the company’s liabilities such as if the company has a total of $150,000 current assets and their liabilities are $100,000. The current ratio percentage could be 1.5. This can be considered as average.
The current ratio of 0.5 means that the company has fewer current assets as compared to the company’s liabilities. It indicates that the company’s liabilities are at a higher stage than the company’s assets.
Conclusion
The current ratio is very important to measure the company’s current assets and liabilities. The higher current ratio indicates that the company has gained much profit as compared to payable amounts, while the low current ratio indicates that the company has higher debt as compared to its total current budget.
Companies can improve their current ratio by reducing inventory, accumulating accounts receivable, and increasing short-term debt. However, the current ratio is just a metric to improve the company’s financial health.