What is Current Ratio?
The Current Ratio is a financial ratio that measures a company's ability to pay off its short-term liabilities with its current assets. Current assets are assets that can be easily converted into cash within one year, like cash, accounts receivable, and inventory. Current liabilities are obligations that are due within one year, like accounts payable, short-term loans, and current portions of long-term debt.
Why Current Ratio Is Important
The Current Ratio is important because it indicates a company's short-term liquidity position. A higher ratio indicates that a company has more current assets relative to its current liabilities, which means it has a stronger ability to meet its short-term obligations. Conversely, a lower ratio indicates that a company may struggle to meet its short-term obligations if its current assets are not sufficient to cover its current liabilities.
How to Calculate Current Ratio
The formula for calculating the Current Ratio is as follows:
Current Ratio = Current Assets / Current Liabilities
For example, if a company has $500,000 in current assets and $300,000 in current liabilities, its Current Ratio would be calculated as:
Current Ratio = $500,000 / $300,000 = 1.67
A Current Ratio of 1.67 indicates that the company has $1.67 in current assets for every $1 in current liabilities. Generally, a Current Ratio of 2 or higher is considered good, while a ratio of less than 1 may indicate financial distress.