What is the current ratio?
The current ratio is a measure of the liquidity of a company’s balance sheet. It is calculated by dividing the current assets by the current liabilities, and it can be interpreted as follows:
A higher current ratio indicates that a company has more assets to pay off its debts, while a lower one suggests that it may have difficulties in paying off its debts.
The Importance of the Current Ratio in Financial Resilience
This ratio is used to assess the ability of a company to meet its short-term debt obligations. It is also often used as an indicator of financial strength. The higher the current ratio, the better protected from bankruptcy. It compares a firm’s current assets to its current liabilities, and can be expressed by the following formulae:
Current Ratio = Current Assets / Current Liabilities
A good current ratio will vary depending on the industry, but a general rule of thumb is a 1:1 or higher.
There are two ways to calculate the current ratio:
1. Current assets divided by current liabilities, or
2. Current assets minus inventory divided by current liabilities minus inventory
The first method is called “acid-test” ratio because it only looks at what can be turned into cash quickly in order to pay off debts. The second method is called “working capital” because it considers how much of a company’s assets are used in its day-to-day operations.
