Liquidity ratios, like the current ratio, are used to evaluate the firm's ability to pay its short-term debt obligations such as accounts payable (payments to suppliers) and accrued taxes and wages on time. Short-term notes payable to a bank, for example, may also be relevant.
On the balance sheet, the current portions of the document are assets and liabilities that convert to cash within one year. Current assets and current liabilities make up the current ratio.
Calculation of the Current Ratio
The formula for the current ratio is Current Assets/Current Liabilities with all the information taken off the balance sheet. The accounts usually used to calculate this ratio are the following: Cash, Accounts Receivable, Inventory, Marketable Securities, and Prepaid Expenses. They are your current asset accounts and go in to the numerator of the equation.
For the denominator of the equation, you use current liabilities from the balance sheet. The accounts you generally use are accounts payable, accrued taxes, accrued wages, and possibly short-term bank loans or the portion of them due within one year.
Interpretation
If should look at the direction of your current ratio compared to other years of data for your firm or compared to other firms in your industry. Ratios are meaningless without comparative data. Try using trend analysis or industry analysis.
In general, if your current ratio is above 1.0, you can pay your short-term debts on time and if it below 1.0, you cannot. The latter is not a good position to be in.
Here is a full calculation of the current ratio.
