Current Ratio Definition, Explanation, Formula, Example and Interpretation

The current ratio includes inventory and prepaid expenses in the total current assets calculation within the formula. Inventory and prepaid assets are not as highly liquid as other current assets because they cannot be quickly and easily converted into cash at a known value. The current ratio is a metric used by accountants and finance professionals to understand a company’s financial health at any https://www.bookkeeping-reviews.com/ given moment. This ratio works by comparing a company’s current assets (assets that are easily converted to cash) to current liabilities (money owed to lenders and clients). The commonly used acid-test ratio (or quick ratio) compares a company’s easily liquidated assets (including cash, accounts receivable and short-term investments, excluding inventory and prepaid) to its current liabilities.

Pros and cons of current ratios

The current ratio relates the current assets of the business to its current liabilities. A very high current ratio could mean that a company has substantial assets to cover its liabilities. However, it could also mean that a business is not using its resources effectively.

Seasonal and industry impacts

A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make current debt payments. The volume and frequency of trading activities have high impact on the entities’ working capital position and hence on their current ratio number. Many entities have varying trading activities throughout the year due to the nature of industry they belong. The current ratio of such entities significantly alters as the volume and frequency of their trade move up and down. In short, these entities exhibit different current ratio number in different parts of the year which puts both usability and reliability of the ratio in question.

  1. The current ratio of such entities significantly alters as the volume and frequency of their trade move up and down.
  2. Another ratio, which is similar to the current ratio and can be used as a liquidity measure, is the quick ratio.
  3. The current ratio includes inventory and prepaid expenses in the total current assets calculation within the formula.
  4. Since Charlie’s ratio is so low, it is unlikely that he will get approved for his loan.
  5. Ratios in this range indicate that the company has enough current assets to cover its debts, with some wiggle room.

Formula and Calculation for the Current Ratio

A current ratio of less than 1 means the company may run out of money within the year unless it can increase its cash flow or obtain more capital from investors. A company with a high current ratio has no short-term liquidity concerns, but its investors may complain that the quick guide to retained earnings it is hoarding cash rather than paying dividends or reinvesting the money in the business. If a company has $2.75 million in current assets and $3 million in current liabilities, its current ratio is $2,750,000 / $3,000,000, which is equal to 0.92, after rounding.

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