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What is the current ratio and how do you measure it?

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Question: What is the current ratio and how do you measure it?
Answer:

The current ratio is probably the best known and most often used of the liquidity ratios. Liquidity ratios 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. 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 current ratio is calculated from balance sheet data as Current Assets/Current Liabilities. So, if a business firm has $200 in current assets and $100 in current liabilities, the calculation is $200/$100 = 2.00X. The "X" (times) part at the end is important. It means that the firm can pay its current liabilities from its current assets two times over.

Intrepretation and Current Ratio Analysis

This is obviously a good position for the firm to be in. It can meet its short-term debt obligations with no stress. If the current ratio was less than 1.00X, then the firm would have a problem meeting its bills. So, usually, a higher current ratio is better than a lower current ratio with regard to maintaining liquidity.

For more analysis of the current ratio, see Lesson 2 of the e-course Financial Analysis Using 13 Financial Ratios

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