“Change your thoughts and you change your world.” Norman Vincent Peale
The first ratio we’ll look at is the Current Ratio. This ratio measures the amount of current assets in a company that are available to pay for its current liabilities.
If you recall from part 1, current assets are the type that can be converted into cash within a year or less. Current liabilities are those that will be due for payment within a year.
A very simplified example of this ratio is as follows: Suppose that you have $1,000 in the bank, and that you also have a $500 credit card bill that’s due this month. If we wanted to calculate your current ratio, in other words, determine how much in current assets ($1,000) you have to cover your current liabilities ($500), all we would need to do is divide $1,000 by $500 = 2.
Your current ratio is 2, which means that you have two times more in current assets than in current liabilities. This is a good sign of liquidity. If your ratio is 1, it would indicate that you have exactly the same amount in current assets as you do in current liabilities.
A ratio of 1 or less is a worrisome ratio for any company to have. It’s a sign of liquidity problems that may continue to deteriorate in the coming periods. The standard ratio is 2:1, which indicates that there are twice as many current assets to pay for current liabilities.
To reiterate, the formula to calculate the current ratio of any company is:
Current Ratio = Current Assets / Current Liabilities
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