Financial Ratios Series – Liquidity Ratios Part 2

“Change your thoughts and you change your world.” Norman Vincent Peale

Current Ratio

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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