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Understand what the current ratio means, how it is calculated, and how it helps measure a company’s short-term liquidity and financial health.
The current ratio is a key liquidity metric that evaluates a company’s ability to meet its short-term liabilities with its short-term assets.
It indicates whether a business has enough resources to cover obligations due within a year, offering insight into its operational stability and liquidity management.
A higher ratio suggests strong liquidity, while a very high or very low ratio may reflect inefficiency or financial stress.
The current ratio measures how efficiently a company can pay its short-term debts using assets that can be easily converted into cash.
It is one of the most widely used liquidity ratios by analysts, creditors, and investors to assess a firm’s financial resilience.
A current ratio of 1 means the company has equal current assets and liabilities, whereas a ratio above 1 indicates a comfortable liquidity position.
The formula to calculate the current ratio is:
Current Ratio = Current Assets ÷ Current Liabilities
| Component | Explanation |
|---|---|
Current Assets |
Assets expected to be converted into cash within a year (cash, receivables, inventory). |
Current Liabilities |
Obligations due within a year (trade payables, short-term loans, accrued expenses). |
Let’s understand with an example:
Current Assets: ₹5,00,000
Current Liabilities: ₹2,50,000
Current Ratio = ₹5,00,000 ÷ ₹2,50,000 = 2.0
This means the company has ₹2 in current assets for every ₹1 of current liabilities, implying a strong liquidity position.
The current ratio offers several analytical advantages:
Quick Liquidity Insight: Provides an instant view of the company’s ability to meet short-term obligations.
Comparative Benchmarking: Useful for comparing liquidity across firms or tracking changes over time.
Lender Confidence: A stable ratio improves creditworthiness and access to financing.
Operational Assessment: Indicates whether working capital is being managed efficiently.
Despite its usefulness, the ratio has limitations:
Doesn’t Reflect Cash Flow Timing: Assets like inventory may not convert quickly into cash.
Can Be Distorted: A high ratio may indicate idle assets rather than liquidity strength.
Industry Variation: What’s considered healthy varies widely across sectors.
Ignores Asset Quality: It assumes all current assets are equally liquid and collectible.
Thus, it should be analysed alongside quick and cash ratios for a fuller picture.
The current ratio offers a broader liquidity view, while other ratios provide stricter assessments of solvency.
| Ratio | Formula | Focus |
|---|---|---|
Current Ratio |
Current Assets ÷ Current Liabilities |
Measures total liquidity. |
Quick Ratio |
(Current Assets - Inventory) ÷ Current Liabilities |
Focuses on most liquid assets. |
Cash Ratio |
Cash & Equivalents ÷ Current Liabilities |
Shows cash-only coverage ability. |
The current ratio is vital across stakeholder groups:
Investors: Assess short-term solvency before investing.
Creditors: Evaluate repayment capability before extending credit.
Management: Monitor working capital efficiency and liquidity trends.
Regulators: Identify potential liquidity risks in financial institutions.
Generally, a ratio between 1.5 and 2.0 is considered healthy, though industry benchmarks vary.
The current ratio remains a fundamental indicator of short-term financial strength.
It helps determine whether a business can sustain daily operations and meet immediate obligations.
Key takeaway:
A ratio around 2 often reflects good liquidity.
Below 1 signals potential liquidity stress.
Above 3 might indicate underutilised assets.
Regular monitoring ensures balanced financial management and business stability.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
The current ratio measures a company’s ability to meet its short-term obligations using its short-term assets, providing a clear view of liquidity and overall financial stability.
The current ratio varies by industry; capital-intensive businesses generally operate with lower ratios, while service-oriented firms maintain higher liquidity due to fewer inventory requirements.
For example, if a company has ₹3,00,000 in current assets and ₹1,50,000 in current liabilities, its current ratio is 2, meaning it has twice as many assets as liabilities, showing strong liquidity.
The current ratio is calculated using the formula Current Assets ÷ Current Liabilities, which determines how efficiently a company can pay off its short-term debts with its available resources.
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