• Calculate the current ratio

 

The current ratio measures the ability of a firm to pay its current liabilities with its cash and/or other current assets that can be converted to cash within a relatively short period of time.

The calculation for the current ratio is as follows:

[latex]\dfrac{\text{current assets}}{\text{current liabilities}}[/latex]

For example: [latex]\dfrac{911,000}{364,000}=2.5[/latex]

Interpretation: This company has 2.5 times more in current assets than it has in current liabilities. The premise is that current assets are liquid; that is, they can be converted to cash in a relatively short period of time to cover short-term debt.

A current ratio is judged as satisfactory on a relative basis. If the company prefers to have a lot of debt and not use its own money, it may consider 2.5 to be too high – too little debt for the amount of assets it has. If a company is conservative in terms of debt and wants to have as little as possible, 2.5 may be considered low – too little asset value for the amount of liabilities it has. For an average tolerance for debt, a current ratio of 2.5 may be considered satisfactory. The point is whether the current ratio is considered acceptable is subjective and will vary from company to company.

Also, the current ratio, like working capital, may include items like inventory and prepaid expenses that are not all that liquid, especially if the company has slow-moving items in inventory (like a yacht builder or home builder). In those cases, the quick ratio or acid test ratio may be better measures of short-term liquidity.