Current Ratio Formula and explanation

Current ratio is the measure of short term solvency. This is ratio between the current assets and current liabilities.Current assets and current liablities are also called working capital of the company. This can best be explained with current ratio formula and interpretation given below.

FORMULA

Current Ratio =

Current Assets

Current Liabilities

EXAMPLE

Current Ratio is calculated by dividing Current Assets with Current Liabilities of the company as appearing in financial statements (statement of financial position).

Current Ratio =

2,152,920

791,840

Current Ratio =

2.718 times

Data used in calculating ratio is extracted from Hypothetical Financial Statements. (See Hypothetical Financial Statements used in calculation).

MEASUREMENT UNIT

Current ratio can either be measured in times or in currency units (dollars).
Using the above example the company has 2.718 times current assets to satisfy its current liabilities or the company has 2.718 dollars in current assets for each 1 dollar current liability.

INTERPRETATION

How to interpret the ratio


The ratio indicates how many times current assets of the company will be sufficient to pay the current liabilities of the company. For settling current liabilities (which are obligations of the company to be settled within following 12 months) the current assets are prime source since these will also be realized within 12 following months.

Therefore if current assets of the company are equal to current liabilities i.e. ratio is 1, the company has current assets equal to its current liabilities for settlement.
If Ratio is greater than 1 (> 1) the company has more current assets than its current liabilities for settlement thus satisfied liquidity. However if ratio is too high e.g. 7 or 8 it means company is too much reserve in borrowings for running business.

If Ratio is less than 1 (< 1) the company has fewer current assets than its current liabilities for settlement thus unsatisfied liquidity. It means if all the current liabilities fall due at once company has to use its long term assets for satisfying the current liabilities.


Users’ needs addressed by the ratio


Creditors are most common users of short term solvency ratios as they are making transactions with the company on short term credit (10 days to 3 months). Creditors are interested to check that company’s current liabilities have sufficient cover of its current assets to meet the obligations as fall due.
If current ratio is below 1 creditors will be cautious in dealing with the company on credit. Moreover they will check other non financial information before extending the credit facility to company.

Management is another user of current ratio. This is linked with the creditors since management wishes to have creditworthiness for its creditors in order to run its business smoothly. Therefore management critically monitors the current ratio.

(You might want the understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).

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