In financial accounting, many different ratios are utilized to indicate to those both inside and outside of a business how well or poorly that business is performing. One group of ratios that accountants use is called the liquidity ratios, and these include the quick ratio, the operating cash flow ratio, and the one we are discussing today – the current ratio. The current ratio is applied to figures found on the balance sheet, and is utilized not only by a business’ managers, but also its potential creditors.
Today we will analyze the current ratio, explaining how it is used, and what the actual ratio means. If accounting and the math involved in that career seem interesting to you, this course on the basics of financial accounting will introduce you to the career, and this course on ratio analysis explains the more math-orient aspects of accounting.
The Current Ratio Explained
The current ratio, or working capital ratio, is a measure of company’s liquidity, and is a good indication of their ability to meet their short-term debt obligations. In other words, it lets people know if the business has the resources to pay their debts over the next 12 months. Those that would be most interested in this information are potential creditors, who would be curious to know whether or not they could be payed back in a timely manner. This ratio would also be of interest to the managers and owners of the business, because the current ratio also gives an idea of how efficient their operating cycle is, which indicates how fast they are able to turn their service or product into cash. To learn more about accounting, this article on its basic concepts
- Current Ratio = Current Assets/Current Liabilities
The two amounts that make up the current ratio are found on the balance sheet. All of the current assets are added up, then divided by the current liabilities. Current assets are those assets that are expected to be converted into cash within the next year, and include any type of cash, receivables, temporary investments, office supplies, raw materials, and finished goods. Current liabilities are debts that are due within 12 months, and include payables, unearned revenue, and other short-term debts.
- High and Low Current Ratios
The higher the current ratio, the more liquid it is, and vice versa. A low value would be less than 1, and would indicate that the business has trouble paying off current debts. A current ratio that is more than 2 would be deemed too high, and it can be assumed that the company is not using its current assets and short-term financing facilities efficiently. Though acceptable current ratios differ from industry to industry, a ratio of about 1.5 is considered good for most industrial companies.
While a current ratio that is too high is considered to be better than one that is too low, there are other factors that need to be considered by possible creditors. One of those factors is operating cash flow. If a company has a current ratio on the low side, it can be bolstered by a strong operating cash flow.
Example of the Current Ratio
Now that you have a pretty good idea of what the current ratio is all about, it’s time to show you how one would be calculated. Below is a portion of a sample balance sheet, with the information needed to calculate the current ratio.
|Assets and Liabilities as of 12/31/13|
|Deferred Tax Payable|
|Income Tax Payable|
Because all you need for the current ratio are current assets and liabilities, you can disregard the non-current accounts. All pertinent amounts have been added up for us, so all that’s left is to divide these amounts:
Current Assets (225)/Current Liabilities (100) = 2.25
This company has an unusually high current ratio, meaning they might not be using their current assets efficiently to pay off their short-term debts. While this current ratio may scare away some creditors, we don’t know what industry ABC Ltd. is in, and perhaps a current ratio of 2.25 is not so bad.
The current ratio is pretty simple to use, yet offers very useful information to a company’s possible creditors. The world of financial accounting is full of interesting ratios that are used to express the various financial situations that a business is in, not only right now, but also in the near future. If these ratios are getting you excited about accounting and you’d like to learn more, this two-part accounting course, part one, and part two, cover this career from the basic concepts to more advanced ones.