The Current Ratio is a liquidity ratio that measures a company’s ability to pay off its short-term liabilities with its short-term assets. The higher the Current Ratio, the more capable the company is of paying its obligations, as it has a larger proportion of asset value relative to the value of its liabilities.
The formula for the Current Ratio is:
Current Ratio = Current Assets / Current Liabilities
For example, if a company’s current assets amount to $5,000,000 and its current liabilities are $2,500,000, the Current Ratio would be:
Current Ratio = $5,000,000 / $2,500,000 = 2
A Current Ratio of 2 means that the company has twice as many current assets as current liabilities, implying that it can cover its short-term obligations twice over.
In general, a Current Ratio above 1 means that the company should be able to meet its short-term obligations without additional financial support. However, an excessively high Current Ratio could also indicate that the company is not using its current assets efficiently to grow the business. Thus, a balanced Current Ratio that is not too high or too low is generally the most favorable.