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Business Financials – Current Ratio – What does this financial ratio tell us?
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Published on Thursday, 06 October 2016 12:59
Several financial ratios can be used to analyse your business, including the current ratio which shows the proportion of current assets to current liabilities. The current ratio is known as an indicator of a company's liquidity. In other words, it shows when there is a large amount of current assets in relationship to a small amount of current liabilities, there is some assurance that the obligations coming due will be paid.
The Current Ratio is calculated as – Current Assets / Current Liabilities
As an example, if a company's current assets amount to $500,000 and its current liabilities are $250,000 the current ratio is 2:1. If the current assets are $600,000 and the current liabilities are $500,000 the current ratio is 1.2:1. Clearly a larger current ratio is better than a smaller ratio. Industry generally says that a current ratio that is less than 1:1 indicates insolvency, and the preference is at least 2:1, or over 2.
When benchmarking a company, or comparing your own, it is wise to compare a company's current ratio to those in the same industry. It is also worth keeping a close look at the trend of the current ratio for a given company over time. Is the current ratio improving over time, or is it deteriorating?
The composition of the current assets is also an important factor. If the current assets are predominantly in cash, and accounts receivable, that is more valuable than having the majority of the current assets in slow-moving inventory.
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