Current Ratio

Current ratio is the ratio of current assets of a business to its current liabilities. It is the most widely used test of liquidity of a business and measures the ability of a business to repay its debts over the period of next 12 months.

Formula

Current ratio is calculated using the following formula:

Current Ratio =Current Assets
Current Liabilities

Both the above figures can be obtained from the balance sheet of the business. Current assets are the assets of a business expected to be converted to cash or used up in next 12 months or within the normal operating cycle of the business. Current liabilities on the other hand are the obligations of a business which need to be settled within next 12 months or within the normal operating cycle.

Analysis

Current ratio matches current assets with current liabilities and tells us whether the current assets are enough to settle current liabilities. Current ratio below 1 shows critical liquidity problems because it means that total current liabilities exceed total current assets. General rule is that higher the current ratio better it is but there is a limit to this. Abnormally high value of current ratio may indicate existence of idle or underutilized resources in the company.

Examples

Example 1: On December 31, 2009 Company A had current assets of $100,000 and current liabilities of $50,000. Calculate its current ratio.

Solution
Current ratio = $100,000 ÷ $50,000 = 2.00

Example 2: On December 31, 2010 Company B had total asset of $150,000, equity of $75,000, non-current assets of $50,000 and non-current liabilities of $50,000. Calculate the current ratio.

Solution
To calculate current ratio, we need to calculate current assets and current liabilities first:
Current Assets = Total Asset − Non-Current Assets = $150,000 − $50,000 = $100,000
Total Liabilities = Total Assets − Total Equity = $150,000 − $75,000 = $75,000
Current Liabilities = $75,000 − $50,000 = $25,000
Current Ratio = $100,000 ÷ $25,000 = 4.00

Written by Irfanullah Jan