Current Ratio - is one of the most popular financial ratios, which determines how much of current liabilities can be paid in short term period using current assets. While talking about this ratio - short term period is one year. This ratio shows what is the level of assets that can be liquidated in one year and how much of companies’ liabilities can be financed of it. This ratio is calculated by dividing short term (current) assets by short term liabilities.
This ratio is showing the financial strength of the company. The result of the ratio should be between 1 and 2. If the ratio is higher than 1, it means that company has enough short term assets to finance current obligations, but it is possible that the company is facing a serious problem as well. Short term assets consist of raw material inventory, products made and stocked, cash in bank, loans and advances made by the company. It means that if the current ratio is too high it is possible, that the company is not managing inventory in the stock very well. Even if those goods that are held in the stock are liquid, in some cases there can be no demand for them, and they may be stocked for a very long time, which is not effective for a company at all.
Usually, for production companies current ratio is higher than 1, because companies that produce some goods, keep some raw materials in stock and they have some of the production stocked as well. Let’s imagine that the company is producing wooden chairs. Such company should have wood in the stock, and some chairs that are ready for sale. If we notice, that in such company current ratio is increasing, we should look at the inventories: maybe the company is not able to sell its production. In such situations it faces a problem of its stocked production to become unfashionable and less illiquid. And it can face very similar problem with raw material - if it has an expiry date, the company might loose from writing it down to losses. So, this example shows how it is important to control inventory in the company.
Because of the difference of the company type, it can be, that current ratio can be lower than 1. Usually it happens for commercial or service companies. It means that the company, which is providing a service, doesn’t need any inventory or stocking, and it will have lower assets. So for some time, the company might have more current obligations than current asset. If the commercial company is controlling stocked production very well, it will have lower current ratio. Such company will have in the stock only needed amounts of goods and a little bit more to avoid delivery lag risk. Such company will order only the amounts of goods that will be enough to serve market demand for its products.
For companies it is useful to follow “correct” current ratio definition, because it is showing them possible problems and informs about needed restructuration in inventory, investments, cash balance, debts and management of effectiveness. For investors this ratio shows how financially healthy the company is. And for suppliers this ratio is important, because they can know that made purchases will be covered in near future and the company will have enough cash to fulfill its obligations.
When analyzing current ratio, it is useful to calculate quick ratio as well, because it is easier to indicate a problem in inventory controlling if the current ratio is rising while quick ratio is staying still. Quick ratio helps to evaluate a company by excluding inventory factor from the current assets. It means that quick ratio evaluates more liquid assets which can be cashed out more quickly.
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