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Current ratio The current ratio is a measurement of a company's ability to pay short term liabilities. The downside of this ratio is that is doesn't account for the ability to liquidate inventory. The current ratio can be calculated as follows: Current ratio = (inventory + accounts receivable + cash equivalents) / Current liabilities Example calculation: Total current assets = 760 million
Which represents $2.53 of current assets per $1 of current liabilities When using any liquidity ratio, generally accepted current ratio values will vary by industry and should only be compared to other companies in the same industry. Generally, a value of at least 1 is required, and the higher the number, the better. (A ratio of less than one means the company cannot meet it's current liabilities and a value of 2 would mean the company could cover the liabilities twice.) Generally, higher numbers are a favorable indicator of the ability to pay short-term debts and very high ratio values can indicate poor receivables or excess cash reserves.
Out of the three main liquidity ratio's, typically the current ratio will tend to overstate the short term liquidity and the cash ratio will tend to understate the short term liquidity and somewhere in the middle is the acid test/quick ratio. Note: Ratios should not be used as the only valuation method since ratios are only as reliable as the data on which they are based. Ratio's should therefore be supplemented with other complementary methods to achieve a reasonable opinion. |
