Current Ratio
The current (total) liquidity ratio (current ratio) is a measure of the organization's solvency, the ability to repay current (up to a year) liabilities of the organization. Lenders widely use this ratio in assessing the current financial position of the organization, the danger of issuing short-term loans.
The logic behind the calculation of this indicator is that an enterprise repays short-term liabilities mainly at the expense of current assets; therefore, if current assets exceed current liabilities, the enterprise can be considered to be successfully operating.
According to the classification of property by speed of sale, there are 3 main types of liquidity indicators:
- Absolute — for property with a high speed of sale.
- Fast, which may also be called the intermediate coverage ratio, — for assets with a high and fast speed of sale.
- Current — for property whose sales rate corresponds to the sum of all 3 listed velocities.
In the existing formulas for calculating liquidity, the ability of each set of property types to repay debt is evaluated in relation to the legal entity's short-term liabilities present.
Calculation of Current Ratio
Current liquidity ratio is calculated as follows: current ratio equals to current assets divided by the current liabilities.
The calculation of current ratio is made from the balance sheet: the numerator of the formula is taken from the assets of the balance sheet, the denominator is taken from the liabilities.
Calculated from the firm's balance sheet data as the quotient of current assets divided by current liabilities, it shows whether the firm has sufficient funds that can be used to repay short-term liabilities. It is one of the company's liquidity indicators, characterizing its ability to withstand rapid changes in market conditions and the business environment, such as delays in payments by customers, fluctuations in sales, unforeseen expenses or demands for immediate payment of debts.
It is generally accepted that this ratio should not be less than 1, but the recommended values may vary significantly depending on industry, country, and other conditions.
Normal value of Current Ratio
The higher the value of the ratio of current liquidity, the higher the liquidity of the company's assets. The normal, and often optimal, value of the coefficient is considered to be 2 or more. However, in world practice it is allowed to reduce this figure for some industries to 1.5.
The value of the current ratio below the norm (below 1) indicates the probable difficulties for the company in repaying its current obligations. But to complete the picture, you need to look at the cash flow from the operating activities of the organization - often a low current ratio is justified by a strong cash flow (eg, in fast food chains, retail trade).
A too high current ratio is also not desirable, as it may reflect an inefficient use of current assets or short-term financing. In any case, creditors prefer to see a higher current ratio as a sign of a company's sustainable position.
