Definition: The Current Ratio is the part of the liquidity ratio that helps to determine the firm’s ability to pay off its short-term obligations with its Current Assets. Simply, a firm uses the current assets, such as cash, cash equivalents, marketable securities, bills receivables, etc. to meet its short-term debt.
Generally, the current assets more than twice the current liabilities are considered favorable, as it shows the firm’s readiness to meet its obligations when they arise. Current liabilities are generally the obligations that are expected to become due within 12 months, and these are in the form of loans and advances, creditors, bills payable, etc.
An ideal way to judge the performance of the company is to compare its current ratio with the other companies within the same industry. This ratio helps the firm to determine its efficiency to pay for the current debt as well as helps in the planning of future payments on the basis of the trend followed by the current ratios calculated in the past 5 to 7 years.
The formula for calculating the current ratio:
Current Ratio = Current Asset/ Current Liabilities
The Higher value of current ratio shows the readiness of a firm to pay for its current obligations when they arise. Thus, higher the ratio higher is the liquidity of the firm.
Example: Suppose a firm has its current assets and current liabilities worth Rs 15,00,000 and Rs 5,00,000 respectively. Then the current Ratio of the firm will be:
Current Ratio = 15,00,000/5,00,000 = 3:1