Definition: The current ratio is a financial ratio that measures a company’s ability to pay off its current obligations with current assets. Management and external users analyze this ratio to judge the liquidity of the company as well as its efficiency.
What Does Current Ratio Mean?
The current ratio formula is calculated by dividing total current assets by total current liabilities. This calculation shows investors, creditors, and management how well the short-term debt can be paid off using short-term assets. This is an important calculation for two main reasons.
First, current debt consists of the loans, notes, and payables that are due in the next 12 months. These are the obligations that the company will have to come up with the cash to pay in the next year. Obviously, both management and external users want to make sure the company doesn’t default on its current obligations.
Moreover, they also don’t want to see the company selling off fixed assets or long-term assets to pay for the current obligations. The current ratio measures the current assetsas a percentage of the current liabilities to show the amount of current debt that can be paid off with current assets like cash, inventory, and receivables.
Second, this ratio shows how easily a company can come up with the money to pay its debts. In other words, it shows how liquid it is. Higher current ratios indicate that more debt can be covered.
Let’s look at an example.
Pete’s Fishing Shop is a small-town bait and tackle shop that sells retail fishing equipment and outdoors gear. At the end of the year, Pete has $20,000 of cash, $5,000 of receivables, and $20,000 of inventory. He also had $15,000 of debt that will become due in the next accounting period.
Pete’s current ratio is 3 (($20,000 + $5,000 + $20,000) / $15,000). This means that Pete has three times more current assets than current liabilities. Pete could pay off all of his current debt and still have two thirds of his current assets remaining.