What is Current Ratio?

A current ratio of a company or a business means its potential to meet its short-term liabilities using its short-term assets. By calculating this ratio, you can estimate the liquidity position of a company before investing in it.

A higher ratio typically signifies higher liquidity, and a lower ratio indicates that a company might have a cash flow issue.

With an increasing number of direct stock market investors, currently standing at 19.43 crore, you must learn about the ratio in detail, its components, and the calculation to make informed investments and ensure liquidity.            

A Brief About the Current Ratio

A current ratio of a company indicates the availability of that company to meet its immediate liabilities with its current assets.

Also known as the working capital ratio, the current ratio is one of the different liquid ratios that determines a company’s ability to fulfil its liabilities using cash or cash equivalents.

Focusing on the aspect of short-term liabilities, this ratio considers those liabilities that are especially needed to be met within 12 months. Therefore, a good current ratio of a company signifies that it is capable of optimising its existing assets to meet its liabilities.

Thus, using it, you might be able to estimate whether your chosen company can sustain its operation by not relying on additional borrowing, reducing any short-term risk before your investment.

It might happen that you do not find this ratio at the time of investing. For that, you might resort to the recorded current assets and liabilities section recorded in their balance sheet.

To calculate it, you can use a simple formula where you divide the current liabilities by the current assets.

Components of Current Ratio

Now that you know what the current ratio is, you must also note its main components that help with the current ratio calculation. It has two main components:

1. Current Assets

Current assets are those assets that a company can liquidate or convert into cash within 12 months. They include in-hand cash, money deposited across bank accounts, and other money-market instruments.

Accounts receivable are also current assets, which essentially are the money that a company owes from its customers and clients.

There are marketable securities such as stocks, bonds, etc, that a company intends to hold for less than 12 months. Liquid assets under a year, aside from the discussed ones, also fall under the current asset category.

2. Current Liabilities

Obligations or liabilities that a company must meet within a year are referred to as its current liabilities. They include accounts payable, which is the opposite of accounts receivable, where the company owes money to its customers and clients.

Outstanding salaries or wages are also current liabilities, i.e. the unpaid wages or salaries of employees of that organisation or company.

There is also a current portion of debt, and by current portion, it means the portion of debt that the company must pay within 1 year. Other liabilities include obligations other than the mentioned ones.

How to Calculate Current Ratio?

After having a clear idea of the current ratio and its components, you must know how to calculate it to determine a company’s performance before investing in it. For this, you must note the current ratio formula:

Current Ratio = Current Assets / Current Liabilities

To understand it in a better way, let us resort to an example for an in-depth explanation:

Suppose the company you are tracking to invest in has cash worth INR 3 crore. It has marketable securities worth INR 2 crore. It is currently boasting an inventory of INR 1.5 crore.

For short-term debt, the figure here is INR 1 crore, and its accounts payable are also the same.

Now, calculate its current assets by adding the cash, marketable securities, and inventory. Thus, it results in INR 6.5 crore.

To calculate the current liability, sum up its current short-term debt and accounts payable. It results in INR 2 crore.

By applying this in the above formula, we get:

Current Ratio = 6.5 crore / 2 crore = 3.25

Thus, the current ratio of the company is 3.25, which companies represent as 3.25x. It means the business has enough capital to meet its short-term liabilities.

What is a Good Current ratio?

As you already noted, the current ratio of a company means how well the current company assets meet the current short-term liabilities of a company.

Thus, the higher the ratio is, the better. In continuation of the above example, as the resulting current ratio is 3.25x, it means that the company boasts assets capable of covering its current liabilities by 3.25 times.

However, an efficiency ratio depends on the industry in which a company operates. Generally, a ratio of 1.5 to 3 or above is considered good for a company to meet its short-term liabilities.

Still, there might be exceptions where companies or industries might be performing well, even having a lower current ratio.

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A Few Key Benefits of Current Ratio

Apart from noting the current ratio meaning, its components and calculation, you must note its key benefits or advantages, as they might be helpful for investment decisions:

1. Easy and Faster Company Assessment

As a current ratio showcases a company’s ability to meet its short-term obligations with numbers, it makes it easy for you to evaluate quickly and easily. It helps you measure the immediate financial health of a company. It helps decide whether its liquidity position makes it a safer stock to invest in.

2. Indicator of Risks

A very low ratio (typically below 1.5) might be an indicator that a company bears a higher level of default risk. At the same time, a very high current ratio (i.e. more than 3) might indicate that a company has idle assets.

3. Effective for Comparative Analysis

A good current ratio generally suggests a company having an efficient liquidity position, higher sales, etc, and thus more stability. Therefore, with this ratio, as an investor, you can compare across competing companies or across industries and locate a potential business to invest in.

4. Helps With Inventory Optimisation

From the company’s perspective, having this score helps it optimise its inventory better. It, in turn, might help in reducing its overhead expenses. Such optimisations might make a company attractive for investors to invest in.

Limitations of Current Ratio

Similar to other ratios for assessing the performance of companies, a current ratio also comes with some limitations. As an investor, you must be aware of them to make informed investment decisions:

1. Focuses on the Quantitative Value

To show the potential of a company to meet its current obligations, the current ratio focuses on the quantitative values of its assets. It does not consider the quality of those assets. It is a limitation, as low-quality or hard-to-sell assets might inflate the ratio and provide you with a misleading sense of the true liquidity strength of a company.

2. Probability of Inaccuracy

It might fail to project the accurate strength of the financial health of a company. It is due to the fact that it does not consider factors such as obsolete stocks, sales frequency, etc. Also, it considers the inventory as current assets, and it often overstates the liquidity of a company

3. Distortion due to Irrelevant Changes

The current ratio might be sensitive to changes that might not be connected with the financial health of a company. For example, a company might change or modify its method for inventory valuation. It might influence this ratio, and such a change has nothing to do with repayment capabilities or the financial health of a company.

Conclusion

The current ratio of a company acts as an indicator of how well a company can use its current assets to meet its short-term liabilities. Using an underlying formula, it provides you with a score. The higher the score, the better a company can manage its liabilities in the short term.

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FAQ’s on Current Ratio

1. What causes a low current ratio?

The current ratio of companies might decrease due to an increase in their short-term debts and a decrease in their current assets. Poor sales, slow collection for accounts receivable, increasing inventory costs, a recent debt, etc, might contribute to decreasing a current ratio.

2. What does a current ratio of 2.5 mean?

A current ratio of 2.5 signifies that a company has enough current assets to meet its current liabilities by 2.5 times. Thus, it signifies a decent liquidity position of the company. It might not need to borrow further to maintain liquidity or meet its obligations.

3. What is the ideal current ratio?

The ideal current ratio of companies ranges between 1.5 and 3. However, it is dependent on the industries in which companies operate. Even companies with a low ratio might operate efficiently.

4. What does the current ratio indicate?

The current ratio of a business or company means its ability to meet its current liabilities with its current assets. The higher this ratio is, the more it is capable of meeting its liabilities, which signifies its stability and its growth potential.