The current ratio is a measure used in the financial industry to assess short-term liquidity of the enterprise. It reflects the company’s ability to generate enough money to pay off all debts if they are in force immediately. Although this scenario is unlikely, the ability of companies to quickly realize the assets to meet liabilities testifies to its overall financial condition.
Components Of Current Ratio
Current assets are on the balance sheet and represent the value of all assets that can reasonably be expected to be converted into cash within one year. The following are examples of current assets:
- Cash and cash equivalents
- Marketable securities
Current liabilities are debts and obligations of the company who within one year, appears on the balance sheet of the company. The following are examples of current liabilities:
- Short-term debt
- Accounts payable
- Accrued liabilities and other debts
How To Calculate Current Ratio
The current liquidity ratio shows the proportion of current assets to current liabilities, is calculated by the following formula:
For Example, The Current Ratio
Below are the current assets and current liabilities at Microsoft (msft) with capacity as indicated on the balance sheet at the end of 2017.
To determine the current ratio of Microsoft, we divide current assets by current liabilities:
Current ratio = 159,851,000 $ ÷ $64,527,000 = 2.48
Investors and analysts will consider the current ratio of Microsoft 2.48, to be financially healthy, the company could easily repay its obligations.
The current ratio gives investors an idea whether the company is able to generate enough money to pay off all debts if they are at the same time. The higher the ratio, the more current assets the company has at its disposal to meet its obligations. Thus, the acceptable figures vary depending on the specific industry, the ratio is between 1.5 and 3 generally considered to be healthy.
Liquidity problems can arise for companies who have difficulties collecting receivables. A ratio below 1 means that the company may not be able to repay its current liabilities if all the commitments come at the same time. The coefficient of 1 does not necessarily mean that the company will go bankrupt, as this may be able to provide other forms of financing. However, the current ratio below 1 indicates the company is in poor financial condition. Conversely, too high could mean that the company is not efficiently using its current assets and short-term financing.
Analyzing the current ratio, as in the case of the majority of financial indicators, it is best to compare with their industry peers with similar business models to determine what level of liquidity is the industry standard. In addition, it is important to note that no single ratio can provide a complete picture of the company.