Current Ratio

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Current Ratio equals current assets divided by current liabilities.

The current ratio measures a company's ability to meet its short-term obligations such as paying its creditors, buying raw materials for production etc.. It also serves as an indication of a company's relative efficiency. It is calculated by dividing current assets by current liabilities.

A current ratio greater than 2.0 indicates a company's current assets - those that it can sell in the next 12 months - are twice as large as its short term liabilities. If current liabilities exceed current assets (for a current ratio less than 1) then the company may not be able to meet its short-term debt obligations.

Generally, the higher the ratio, the more liquid the company is. This means the company would have a better short-term financial standing to meet its debt obligations. However, an investor should also take note of a company's operating cash flow in order to get a better sense of its liquidity. A low current ratio is can often be supported by a strong operating cash flow.

On the other hand, if a company is able to operate with a low current ratio, it means that the company is more efficient about using its capital. Therefore, a low current ratio can lead to higher return of assets.

Examples

  • If a company ABC has $10 million in current assets and $5 million in current liabilities, the current ratio would be 2 (10/5 = 2). Company ABC has $2.00 of Current Assets to meet $1.00 of its Current Liability.
  • Company XYZ has $20 million in current assets and $30 million in current liabilities, the current ratio would be 0.67 (20/30=0.67). Company XYZ has $0.67 of Current Assets to meet $1.00 of its Current Liability.
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