The current ratio is a financial metric used to assess a company's short-term liquidity, or its ability to pay off its short-term debts (liabilities) with its short-term assets. Here's how to calculate it:
Formula:
Current Ratio = Current Assets / Current Liabilities
Explanation:
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Current Assets: These are resources that a company can convert into cash within one year. Examples include cash, accounts receivable (money owed by customers), and inventory.
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Current Liabilities: These are financial obligations that a company must pay within one year. Examples include accounts payable (money owed to suppliers), short-term loans, and accrued expenses.
Steps to Calculate:
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Gather Financial Information: You'll need the total amount of a company's current assets and current liabilities. This information can be found on the company's balance sheet, which is usually part of their financial statements.
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Divide Current Assets by Current Liabilities: Simply divide the total current assets by the total current liabilities.
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Interpret the Result:
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A ratio greater than 1 indicates that the company has enough current assets to cover its current liabilities.
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A ratio close to 1 suggests the company might have some challenges meeting its short-term obligations, but it's manageable.
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A ratio significantly lower than 1 might raise concerns about the company's ability to pay its short-term debts.
Here's an Example:
Let's say a company has the following information on its balance sheet:
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Current Assets: $100,000
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Current Liabilities: $75,000
Current Ratio Calculation:
Current Ratio = $100,000 (Current Assets) / $75,000 (Current Liabilities) = 1.33
Interpretation:
In this example, the current ratio is 1.33, indicating that the company has $1.33 of current assets for every $1 of current liabilities. This suggests the company has a good balance of short-term assets to cover its short-term debts.
Remember: The current ratio is just one metric used to assess a company's financial health. It should be considered alongside other financial ratios and overall company performance.