The current ratio is very poplar liquidity ratio; it is used to determine the short term liquidity of the company means that enough current assets (Cash, prepaid Insurance, Cash equivalents, Account receivable and Inventory etc) are available with company to meet it short term liabilities obligations.
In other words current ratio determines the company ability to pay off its short term liabilities via available current assets. In theory, higher the current of the company better will be the liquidity position.
Formula:
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Current ratio figure is calculated after dividing the company current assets with current liabilities of the company.
Example:
Let’s assume company ABC balance sheet contains currents assets of 10,000 dollars and 5,000 dollars current liabilities.
Current Ratio = $ 10,000/$ 5000 = 2.0
Analysis:
The current ratio is a good tool to investigate company liquidity but sometimes it’s misleading. Higher current ratio is not necessarily mean better liquidity and lower current ratio is not necessarily bad liquidity. Current ratio focuses on amount of current assets and liabilities although the fact is that turning current assets to cash require time which varies company to company.
Let compare two companies’ current ratios.
| |Company A |Company B |
|Current Assets |$ 6000 |$ 3,000 |
|Current Liabilities |$ 2000 |$ 1,500 |
|Working Capital |$ 4,000 |$ 1,500 |
| | | |
|Current Ration |3.0 |2.0 |

From the example