Through a series of blogs, we are going to explain some important ratios that are useful for judging the financial health of a company. In this blog, we are going to talk about the current ratio. The Current Ratio is a part of the liquidity ratio. It is calculated to find out the company’s ability to pay off short-term as well as long terms obligations. In order to find the current ratio, the company has to consider its total assets, liquid and non-liquid, and relate them to the total liabilities.
The formula to calculate the current ratio of a company is:
Current Ratio = Current Assets/ Current Liabilities.
This ratio is termed ‘current’ because unlike other liquidity ratios; it takes all the current assets and liabilities into consideration. Thus, it is also known as the working capital ratio.
Here is a Breakdown of the Current Ratio
This ratio helps find a company’s ability to pay off liabilities using its assets like cash, inventory, marketable securities, accounts receivable, etc. Thus, it roughly estimates the financial health of the company. If the ratio is good enough to pay possible debts, then the asset value will be more than the liability. This implies, that if the ratio is less than one, the company does not have sufficient assets to repay its debts, and it might go bankrupt.
If the company begets realistic expectations of future earnings, there are numerous sources to access finance. Suppose, if it possesses some short-term debts, but also has a significant investment that would be due for a short while, then it can quickly cover-up. Still, at any point in time, the company showing a current ratio of less than 1 is not healthy.
Also, this does not mean if the ratio is 3, the company’s finances are healthy. It may have assets that aren’t working efficiently and cannot secure financial debts. But they still exist on the asset side of the balance sheet. The current ratio gives a rough sense of the operating cycle of the company. It provides an idea of the amount of cash that is readily available for paying off debts.
What are the Limitations of the Current Ratio?
No ratio can give a perfect evaluation of a company. However, in order to judge a business on an estimation basis, these rates help different parties connected with the company in several ways. It also begets certain limitations as follows:
- Comparing ratios of different companies does not give a productive result. The operations of business differ among industries, and so do their methods of operations.
- For example, a company might have massive debt through leverage, and the other might have minimum obligations with the view to pay them off as soon as possible.
NOTE: Comparing these two companies will have varying current ratios, and the one with a better number will not necessarily mean it is financially healthy. Instead, comparison among enterprises in the same industry still makes sense.
- Secondly, among different liquidity ratios, this one is the least rigorous. It reflects all the current assets including those that will not be liquidated soon.
- Thus, it does not come out to be such a useful approximation for, in reality, the company is not as liquid as shown in the statistics.