Current Ratio is the liquidity ratio that measures the company’s ability to pay the short term obligations with its short term assets (Cash, Inventory, and Receivables). It is also called as Cash Ratio. The higher the current ratio, the more capable the company is paying its obligations.
The current Ratio formula is Current Ratio = Current Assets/ Current Liabilities. Current Assets are the assets which can be converted into cash within one year. Current liabilities are those that will have to be paid off within a year.
A current ratio under 1 implies that current liabilities exceed current assets of the company and implies that the company is not in good financial status. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems.
The ideal current ratio varies from industry to industry and above 1.50 is considered to be good. However higher current ratio does not indicate good ratio and maybe current assets are underutilized. Holding large levels of current assets may not be profitable to the firm.
The current ratio can be improved by either increasing the current assets or reducing the current liabilities.
The current ratio must be analyzed over a period of time. Increase in the current ratio over a period of time indicates improved liquidity of the company. A decreasing trend in the current ratio may suggest a deteriorating liquidity position of the business.