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Current Ratio Meaning
The Current Ratio is a liquidity ratio that measures a company’s capacity to cover its short-term liabilities with its short-term assets.
Key Takeaways
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The current ratio evaluates liquidity, showing how well a company can cover short-term liabilities with short-term assets.
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An ideal current ratio is between 1.5 and 2.0, balancing financial safety with efficient asset use.
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A low ratio (<1) signals potential difficulty in meeting obligations, while a high ratio (>2) may point to idle or underutilised resources.
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It is most useful when compared with industry peers and used alongside other financial metrics for accurate analysis.
Currency Ratio Formula
The current ratio formula is pretty straightforward. One simply has to take the ratio of a company’s current assets and divide it by its current liabilities in the same duration, which is normally taken as one year. The formula is as follows:
Current Ratio = Current assets / Current liabilities
As per the current ratio formula, it is necessary to know the current assets and liabilities of a company.
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Current Assets include cash, accounts receivable, marketable securities, and inventory that can be converted into cash within a year.
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Current Liabilities include accounts payable, short-term borrowings, accrued expenses, and other debts due within 12 months.
For example, if a company has ₹5 crore in current assets and ₹2.5 crore in current liabilities, the current ratio would be:
5/2.5 = 2
This means the company has ₹2 in assets for every ₹1 of liability, indicating a comfortable liquidity position.
What Is an Ideal Current Ratio?
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Generally, a current ratio between 1.5 and 2.0 is considered ideal.
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A ratio below 1 indicates that the company may struggle to meet short-term obligations, signalling liquidity risk.
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A ratio much higher than 2 could mean the company is not using its assets efficiently, as excess cash or inventory may be sitting idle instead of being invested for growth.
Why is Current Ratio Important?
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Measures Liquidity Position: It provides a snapshot of a company’s ability to handle short-term obligations.
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Assesses Financial Stability: A healthy ratio reassures creditors and investors about the company’s stability.
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Guides Investment Decisions: Investors use it to judge whether a company is efficiently managing working capital.
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Risk Indicator: A very low ratio indicates a higher risk of default, while a very high ratio may suggest idle assets.
Conclusion
The current ratio is a vital tool in financial analysis that provides insight into a company’s liquidity and short-term financial health. While it offers a quick assessment of whether current assets cover current liabilities, it must be analysed in context with industry standards and other financial metrics. A ratio that is too low indicates liquidity risk, while a ratio that is too high may point to inefficiency. Ultimately, investors and businesses should use the current ratio as a starting point in evaluating financial strength, but not the sole deciding factor.