A good current ratio typically falls between 1.2 and 2.0. This range indicates that a company has sufficient current assets to cover its short-term liabilities.
Understanding the Current Ratio
The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations (liabilities) with its short-term assets. It is calculated as follows:
Current Ratio = Current Assets / Current Liabilities
- Current Assets: Assets that can be converted to cash within one year (e.g., cash, accounts receivable, inventory).
- Current Liabilities: Obligations due within one year (e.g., accounts payable, short-term debt).
Interpreting the Current Ratio
- Current Ratio > 1: The company has more current assets than current liabilities, suggesting it is likely able to meet its short-term obligations.
- Current Ratio < 1: The company has more current liabilities than current assets, which may indicate potential liquidity problems. It might struggle to pay its short-term debts.
- Current Ratio between 1.2 and 2.0: This is generally considered a healthy range. It suggests the company has enough liquid assets to cover its immediate liabilities but isn't holding onto excessive amounts of unproductive assets.
- Current Ratio significantly > 2.0: While seemingly positive, a very high current ratio might indicate that the company isn't efficiently utilizing its current assets. For example, it might be holding too much cash or have slow-moving inventory.
Examples
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Company A has current assets of $500,000 and current liabilities of $400,000.
Current Ratio = $500,000 / $400,000 = 1.25 (Good)
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Company B has current assets of $300,000 and current liabilities of $400,000.
Current Ratio = $300,000 / $400,000 = 0.75 (Potentially concerning)
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Company C has current assets of $800,000 and current liabilities of $200,000.
Current Ratio = $800,000 / $200,000 = 4.0 (Potentially inefficient)
Considerations
It's important to remember that the ideal current ratio can vary by industry. Some industries require higher liquidity than others. It's best to compare a company's current ratio to those of its peers in the same industry. Furthermore, the current ratio is just one metric, and a complete financial analysis requires looking at other ratios and indicators.
