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The current ratio is a liquidity measurement used to determine whether a company can meet its short-term obligations without having to sell off assets within a certain period of time, typically a year.
This is one of the most important ratios used to determine whether a company is healthy enough to continue operating without having to raise additional capital. Companies are required to disclose their current ratios in financial statements, and they are generally considered solvent when their current liabilities equal their current assets plus their shareholders’ equity.
A company with a current ratio greater than 1.0 usually does not face immediate cash flow problems because it has enough liquid assets to cover its financial obligations. However, a current ratio of less than 1.0 could mean that the company has too much current debt relative to its total assets. This situation could lead to financial difficulties if the company cannot generate sufficient revenue to repay its debts.
Current ratio limitations
The current ratio is often used to determine whether a firm is financially healthy. However, there are limitations to how well it works.
One limitation of the current ratio is that it does not take into account differences among industries. When comparing different companies with one another, their current ratios may not lead to productive insights. This is because there are several factors impacting this liquidity ratio, such as the fact that not all businesses extend credit to clients for the same time period.
Another drawback of using the current ratio is that it lacks specificity. Because it compares total current assets and total current liabilities, it doesn’t tell much about what kind of assets or liabilities are being accumulated or spent.
This comparison ignores the fact that some assets are held for long periods of time. For instance, a large inventory of raw materials could be considered an asset even though it is likely to remain unsold for months.
Current ratio formula
The current ratio is calculated by dividing the current assets by the current liabilities. This calculation helps investors understand whether a company can pay off its short-term debt without borrowing money.
Current assets represent items that can be turned into cash within one year.
Current Ratio = Current Assets / Current Liabilities