Current Ratio Definition and Interpretation
Current Ratio Definition – “A comparison of a company’s current assets with its current liabilities. To calculate, divide total current assets by total current liabilities”.
It is one of the liquidity ratio. Furthermore, it measure the organization’s ability to meet is short term and long term liabilities. It is also known as working capital ratio. This ratio is named as current as it takes into consideration both current assets and current liabilities
Current Ratio Formula = Total Current Assets/ Current Liabilities
In simple words, it tells about whether firm is capable of paying off its liabilities with respect to its assets. Total Current Assets includes stock or inventory, accounts receivables, cash, cash equivalents, etc. Total current Liabilities includes bills payable, outstanding expenses,accounts payable,etc.
Interpretation of Current Ratio – Why it is Used?
A ratio under 1 signifies that the liabilities of the company is greater than its assets. This means that, if company has to pay off its obligations, then it is insufficient to do so.
Ratio below 1 means that firm is not financially sound. This doesn’t mean that company will become insolvent. But overall, the ratio below 1 is not good for the company.
If ratio is above 1 say 3, it is not a good sign for the company. This directly implies that organization is not using its current assets effectively and efficiently. This also indicates that firm is not utilizing the working capital properly. However the situation becomes more clear by estimation of Acid test ratio or quick ratio. Generally, 1:1 is the ideal ratio. However this may differ with industry to industry.
This ratio is mainly used to compare one organization with other organization. However, one cannot compare the performances of organization just by this ratio. To get clear picture, equal importance is given to other ratios as well.
Example of Current Ratio
Let’s discuss an example in order to understand current ratio definition more clearly. Let say, Reliance Infrastructure has 1 crore of cash, 3 crore investments, 4 crore in inventory, 1 crore debtors and 6 crore liabilities.
So the current ratio = Total Assets / Total Liabilities
= (1+3+4+1) / 6
This signifies that, Reliance Infrastructure is doing well financially. When the time comes to pay the liabilities, they have the sufficient funds to pay off their obligations.