Understanding Current Ratios
The Current Ratio is used to assess the short-term financial position of a company's concern. That means it indicates the company's ability to meet its short-term obligations that are due within one year. It is calculated as Current Assets divided by Current Liabilities. The Current Ratio is also known as Working Capital Ratio.
The formula for Current Ratio
Current Assets -
These are companies' assets that expect to convert into cash within one year. Some current assets are Cash, Bank deposits, Inventory, etc. These assets are found in the company's assets section of the balance sheet.
Current Liabilities -
These are a company's debt obligations that are due to be paid within one year. Some current liabilities are accounts payables, short-term debts, outstanding expenses, etc. Current liabilities are found in the liabilities section of the company's Balance Sheet.
Example of Current Ratio:
For the financial year, DLF Limited reported Current Assets as Rs. 26593.04 Cr. and Current Liabilities as Rs. 12869.13 Cr.
The value as per the formula (current assets / current liabilities) is calculated as (26593.04 / 12869.13) = 2.07.
The current ratio is calculated as Current Assets divided by Current Liabilities and is also popularly known as Working Capital Ratio.
If current assets are double in amount compared to its current liabilities, that is 2:1 or higher is considered good.
A low current ratio indicates a weak liquidity position for the company. It means that the company is insufficient to pay off current liabilities.
While looking at the Current Ratio, the following points should also take into consideration:
The current ratio of two or higher is considered good, indicating that the company can meet its short-term obligations. But if the current ratio is higher than three, it also could mean that the company is not utilizing its current assets efficiently. And the cash or bank balance may be remained because of the fewer investment opportunities.
The current of 2:1 is considered satisfactory because, first of all, it means the current assets are double in amount of its current liabilities, so the company will not face problems to cover current obligations. And secondly, it can provide for losses and delays.
And the low current ratio indicates a weak liquidity position for the company. It means that the company is insufficient to pay off current liabilities.
Some types of Companies with a current ratio below one can operate steadily and comfortably if their inventory turns into cash quickly and continuously than accounts payables due.
This metric also shows the number of times the company can cover its current liabilities by its current assets in one year. So the current ratio of the particular company is three, which means it can cover current liabilities three times by using its current assets.
How to use the Current Ratio effectively
Investors should look for a higher Ratio. If current assets are double in amount compared to its current liabilities, that is 2:1 or higher is considered good. But if it is too high, then also check other relative factors.
Also, look at the company's past performance for better analysis. And even if it is one of the important parameters, the current ratio only measures the quantity of assets and not the quality of current assets, so investors should look at other metrics relative to the current ratio, like Quick Ratio
, Debt to Assets
, Accruals Ratio
, Account Receivable Turnover Ratio
||Screener at TSR
|| Strong Bullish
|3.5 to 5
|2.5 to 3.5
|| Mild Bullish
|2 to 2.5
|1 to 2
|| Mild Bearish
||Shortfall in Assets
|0.5 to 1
|| Strong Bearish
||Deficiency of Assets
Related Current Ratio Screener