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What is the current ratio?

Current ratio

Current ratio is a measure of a company's liquidity. It gauges the extent a company is able to pay its short-term liabilities with its current assets. It's also known as the working capital ratio. A higher current ratio indicates that the company is in good financial health.

Key takeaways:

  • Current ratio is a financial metric that measures a company's short-term liquidity and ability to pay its current liabilities using its current assets.

  • It is calculated by dividing a company's current assets by its current liabilities. A current ratio above 1 indicates that a company has more current assets than current liabilities, which may signify good liquidity.

  • A high current ratio may indicate that a company is in a strong position to meet its short-term obligations, but it may also imply that the company has too much inventory or is not effectively utilizing its assets.

Where have you heard about current ratios?

Investors and financial analysts use the current ratio to gauge a company's financial health against other companies in the same industry, or to track how the company's short-term solvency has changed over time.

What you need to know about current ratios

The current ratio is calculated using this formula:

Current ratio = current assets / current liabilities

For example, a company with assets of $500,000 and liabilities of $250,000 would have a current ratio of 2 (2:1).

A ratio of less than 1 indicates that the company wouldn't be able to pay its liabilities if they all became due and may be heading towards insolvency.

The greater the ratio the more solvent the company currently is. On the other hand, a ratio that is too high might indicate that a company is not using its assets or short term financing efficiently.

The current ratio is a useful measure of liquidity but it has its limitations as it is the most basic form of assessment and is best used alongside other ratios of liquidity, such as working capital or the quick ratio, when evaluating a potential investment.

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