What is the Current Ratio and How Do You Measure It?
What You Need to Know About the Current Ratio
The current ratio is probably the best known and most often used of the liquidity ratios, which are used to evaluate the firm's ability to pay its short-term debt obligations, such as accounts payable (payments to suppliers) and accrued taxes and wages. Short-term notes payable to a bank, for example, may also be relevant.
On the balance sheet, the current portions of the document are assets and liabilities that convert to cash within one year.
Current assets and current liabilities make up the current ratio.
Calculation of the Current Ratio
The current ratio show how many times over the firm can pay its current debt obligations based on its assets.
The current ratio is calculated from balance sheet data as Current Assets/Current Liabilities. So, if a business firm has $200 in current assets and $100 in current liabilities, the calculation is $200/$100 = 2.00X. The "X" (times) part at the end is important. It means that the firm can pay its current liabilities from its current assets two times over.
Interpretation and Current Ratio Analysis
This is obviously a good position for the firm to be in. It can meet its short-term debt obligations with no stress. If the current ratio was less than 1.00X, then the firm would have a problem meeting its bills. So, usually, a higher current ratio is better than a lower current ratio with regard to maintaining liquidity.
Calculating Quick Ratio
The second step in liquidity analysis is to calculate the company's quick ratio or acid test. The quick ratio is a more stringent test of liquidity than is the current ratio. It looks at how well the company can meet its short-term debt obligations without having to sell any of its inventory to do so.
Inventory is the least liquid of all the current assets because you have to find a buyer for your inventory. Finding a buyer, especially in a slow economy, is not always possible. Therefore, firms want to be able to meet their short-term debt obligations without having to rely on selling inventory.
The formula is the following: Quick Ratio = Current Assets-Inventory/Current Liabilities. In the balance sheet, you can see the highlighted numbers. Those are the ones you use for the calculation. For 2008, the calculation would be the following:
Quick Ratio = $708-$422/$540 = 0.529 X
This means that the firm cannot meet its current (short-term) debt obligations without selling inventory because the quick ratio is 0.529 X which is less than 1.0 X. In order to stay solvent and pay its short-term debt without selling inventory, the quick ratio must be at least 1.0 X, which it is not.
- What is liquidity and how are the liquidity ratios used?
- What is the quick ratio and how is it used?
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