Current ratio

Definition

The current ratio is a liquidity ratio that measures a company's ability to cover its short-term obligations with its short-term assets. It is calculated by dividing current assets by current liabilities, providing insights into a company's financial health and operational efficiency. A higher current ratio indicates a greater ability to pay off liabilities, which can enhance investor confidence and stability.

5 Must Know Facts For Your Next Test

1. A current ratio of 1 indicates that a company has exactly enough current assets to cover its current liabilities, while a ratio above 1 shows a cushion for short-term financial stability.
2. A current ratio significantly below 1 may signal financial distress, indicating the company may struggle to meet its short-term obligations.
3. Industry norms vary for acceptable current ratios, so it's important to compare a company's ratio with those of its peers for context.
4. Investors often use the current ratio in conjunction with other financial ratios, such as the quick ratio, to get a fuller picture of a company's liquidity position.
5. Seasonal businesses may experience fluctuations in their current ratio due to varying sales cycles and inventory levels throughout the year.

Review Questions

• How does the current ratio serve as an indicator of a company's financial health?
  • The current ratio serves as an important indicator of a company's financial health by showing its ability to pay off short-term liabilities with its short-term assets. A ratio above 1 suggests that the company has more current assets than current liabilities, signaling good liquidity and stability. Conversely, a low current ratio may indicate potential liquidity issues and raises concerns about the company’s ability to meet its obligations.
• Discuss how industry norms influence the interpretation of a company's current ratio.
  • Industry norms significantly influence how the current ratio is interpreted because acceptable levels can vary widely across different sectors. For instance, capital-intensive industries may have lower current ratios due to higher fixed asset investments, while retail businesses might have higher ratios owing to their inventory turnover. Therefore, comparing a company's current ratio against its industry peers provides more relevant insights into its liquidity position.
• Evaluate the impact of seasonal fluctuations on a company's current ratio and the implications for investors.
  • Seasonal fluctuations can greatly impact a company's current ratio, especially for businesses with distinct sales cycles. For example, retailers might see their current ratios drop after peak holiday seasons due to depleted inventories and increased liabilities from holiday expenses. Investors need to consider these fluctuations when analyzing liquidity because a temporarily low current ratio may not reflect long-term financial health. Recognizing these seasonal patterns allows investors to make more informed decisions based on potential future performance rather than solely relying on snapshot data.

Related terms

liquidity:

Liquidity refers to the availability of liquid assets to a company, which can be easily converted into cash to meet short-term obligations.

current assets: Current assets are assets that are expected to be converted into cash or used up within one year, such as cash, accounts receivable, and inventory.

current liabilities: Current liabilities are obligations that a company is required to settle within one year, including accounts payable, short-term debt, and other accrued expenses.