This article explains the Current Ratio in a practical way. After reading you will understand the basics of this powerful financial management tool.
Introduction
The current ratio is a calculation formula and liquidity indicator that indicates to what extent an organization can repay current liabilities with short term assets.
This ratio is also known as liquidity ratio or cash solvency ratio.
Current Ratio formula
The formula for calculating the current ratio is as follows:
| Current Ratio = | Liquid assets+ debtors + inventories* / Short-Term Liabilities** |
* = Liquid assets are resources that are readily available such as cash and money in bank accounts. Inventories are the products times (x) the cost price that are managed in the warehouse.
** = Short Term Liabilities is the capital that has to be repaid within a short time for example a supplier’s credit, creditors or an overdraft facility.
The outcome of this ratio is often used to form an idea of the organization’s capital. It is about short-term obligations (liabilities) that can be repaid with short-term assets (cash, inventories, receivables).
Rule of Thumb: the higher the Current Ratio, the better the organization is able to repay their short-term liabilities. If the outcome is lower than one, this indicates that the organization is unable to meet its short-term liabilities. This says something about the organization’s financial health, but that does not necessarily mean they are going bankrupt.
The Current Ratio can say something about the efficiency of an organization with respect to turning over products into cash.
Liquidity problems may arise because of long-term outstanding debts, stock management or problems with the bank.
What do you think? Is the Current Ratio still applicable in today’s modern economy and business world? Do you recognize the practical explanation or do you have more suggestions? What are your success factors for using financial ratios in relation of good business management?
Share your experience and knowledge in the comments box below.
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More information
- Bates, T. W., Kahle, K. M., & Stulz, R. M. (2009). Why do US firms hold so much more cash than they used to?. The journal of finance, 64(5), 1985-2021.
- Berger, A. N., & Udell, G. F. (1995). Relationship lending and lines of credit in small firm finance. Journal of business, 351-381.
- Ross, S. A., Westerfield, R., & Jordan, B. D. (2008). Fundamentals of corporate finance. McGraw-Hill Education.
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