Current Ratio – Formula, Meaning, Assumptions and Interpretations

The current ratio is the most popularly used metric to gauge the short term solvency of a company. This article provides the details about this ratio.

Formula

Current Ratio = Current Assets / Current Liabilities

Meaning

Current ratio measures the current assets of the company in comparison to its current liabilities. This means that the firm expects to collect cash from the people that owe it money and pay to the ones that they owe money to on time. Hence if the current ratio is 1.2:1, then for every 1 dollar that the firm owes its creditors, it is owed 1.2 by its debtors.

The ideal current ratio is 2 meaning that for every 1 dollar in current liabilities, the company must have 2 in current assets. However, this varies widely based on the industry in which the company is functioning.

Assumptions

The current ratio makes two very important assumptions. They are as follows:

• The current ratio assumes that the inventory that the company has on hand will be liquidated at the price at which it is present on the balance sheet. However, this may not be the case. Many times inventories become obsolete and have to either be discarded on sold off at a fraction of the cost that they were purchased for. The current ratio does not warn the investors about these risks.

• The current ratio assumes that the debtors of the firm will pay it on time. There is nothing wrong with this belief if it is founded based on strong facts. The analyst must look at the past performance of the firm in collecting its receivables and factor in the late payments and bad debt charges to make the calculation more meaningful.

Wrong Interpretations

• A moderately high current ratio is considered safe and healthy. However, if the current ratio is too high, it means that company is not effectively managing its current assets. Common symptoms include a lot of obsolete inventory as well as trouble getting paid on time by the debtors.

• A current ratio shows the company’s liabilities and assets position for the next 12 months. It is possible that the liabilities may be due in the next 6 months whereas the assets may be due for realization only after 9 months. The current ratio does not provide conclusive information about the liquidity position of the company.

• Since receivables are included in the calculation, an analyst must also be aware about the age of these receivables. Older receivables are less likely to be collected and therefore investors must be careful about making predictions based on these receivables.