Current Ratio

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What is Current ratio?

Current ratio measures a company’s ability to pay short-term liabilities with short-term assets, indicating liquidity and financial health.

How do you interpret Current ratio?

Current ratio measures a company’s ability to pay short-term liabilities with short-term assets, indicating liquidity and financial health. A ratio above 1 suggests good liquidity.

How to Calculate Current ratio?

The Current Ratio is calculated by dividing a company’s current assets by its current liabilities.

Current Ratio = Current Assets / Current Liabilities

where

• Current Assets: Assets that can be converted into cash within a year (e.g., cash, inventory, receivables).
• Current Liabilities: Obligations due within the next year (e.g., accounts payable, short-term debt).

Why is Current ratio important?

It is important because it indicates a company’s ability to meet its short-term obligations using its most liquid assets. It is a key measure of liquidity and financial health.

How does Current ratio benefit investors?

Investors use the Current Ratio to assess the financial stability of a company. A higher ratio can suggest a lower risk of financial distress, making the company more attractive for investment. A very high ratio, however, might indicate that the company is not using its assets efficiently.

Using Current ratio to Evaluate Stock Performance

The Current Ratio does not directly influence stock prices, but companies with a healthy ratio are considered more stable, which can make them more attractive to investors, potentially leading to positive stock performance.

FAQ about Current ratio

What is a Good Current ratio?

A good Current Ratio is generally between 1.5 and 2.0, depending on the industry. A ratio below 1 suggests the company may struggle to meet short-term obligations, while a ratio above 2 might indicate underutilized assets.

What Is the Difference Between Metric 1 and Metric 2?

The Current Ratio includes all current assets, while the Quick Ratio excludes less liquid assets like inventory. The Quick Ratio offers a more conservative measure of liquidity.

Is it bad to have a negative Current ratio?

A negative Current Ratio is not possible because liabilities and assets are typically positive. However, a very low ratio (below 1) can signal liquidity problems, meaning the company may have difficulty covering its short-term obligations.

What Causes Current ratio to Increase?

The ratio increases when a company’s current assets grow or when its current liabilities decrease. This could be due to improved sales, better receivables collection, or reduced short-term borrowing.

What are the Limitations of Current ratio?

It does not consider the timing of cash inflows and outflows and assumes all current assets are liquid, which may not be the case. It also does not account for the quality of the assets, as some assets may not be easily converted into cash.

When should I not use Current ratio?

This ratio may not be reliable in industries with long cash cycles or where current assets, such as inventory, may take a long time to convert to cash. It’s also less relevant when evaluating companies with highly predictable cash flows.

How does Current ratio compare across industries?

The acceptable range for the Current Ratio varies by industry. Capital-intensive industries like manufacturing may have lower ratios, while service-based or technology companies often have higher ratios due to lower working capital requirements .

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