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Business Financials – What is the Current Ratio formula & what does it tell us
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Published on Thursday, 27 October 2022 10:00
Many financial ratios can be used, including the current ratio /formula.
It tells us the proportion or amount of current assets (CA) to current liabilities (CL), and ideally we want 2 x CA to CL.
The current ratio is also an indicator of a company's liquidity. Put in another way, if 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.
“Current” refers to amounts available or due within 12 months, such as cash and credit cards, money debtors owe you and supplier creditors who you need to pay, unlike equipment assets that are help over several years, and finance and loans to be paid over several years, which come under Long-term categories.
Examples - if a company's current assets are $500,000 and its current liabilities are $250,000 the current ratio is 2:1 (500/250 = 2).
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 in comparison to current liability.
Generally, 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, marketable securities, and accounts receivable, that is more valuable than having the majority of the current assets in slow-moving inventory.
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