Definition of Current Ratio
The current ratio is a financial ratio that shows the proportion of a company's current assets to its current liabilities . The current ratio is often classified as a liquidity ratio and a larger current ratio is better than a smaller one. However, a company's liquidity is dependent on converting the current assets to cash in time to pay its obligations.
Example of Current Ratio
If a company's current assets are $600,000 and its current liabilities are $200,000 the current ratio is 3:1. If the current assets are $600,000 and the current liabilities are $500,000 the current ratio is 1.2:1. Obviously a larger current ratio is better than a smaller ratio. Some people feel that a current ratio that is less than 1:1 indicates insolvency. However, some online sellers with customers paying with credit cards at the time of ordering may operate comfortably with a very low current ratio.
It is wise to compare a company's current ratio to that of other companies in the same industry. You are also wise to compare a company's recent current ratio to its ratio at earlier dates. In other words, spotting a trend can be important.
Caution
The composition of the current assets is also an important consideration. If the current assets are predominantly in cash,
marketable securities
, and collectible
accounts receivable
, that is likely to provide more liquidity than a huge amount of slow moving inventory.
