For any business to thrive, it needs to focus on reducing debt and maximizing profitability. And that is no easy task! As there are several well-established companies still in debt and trying to clear it off. However, their yearly turnover and market presence allow them to survive and continue operations. But then, keeping things on a short-term goal basis, companies have to check their liability in fulfilling them. These could be a goal, loan repayment, debt clearing, etc.
When you do such calculations, there is a term that comes up known as the current ratio. A quite prominent financial terminology that provides necessary details on whether the company will fulfill short-term goals or succumb to its debt in the next 12 months.
To know more about it, you must understand it in detail. We have explained everything below for your clear understanding.
What is the Current Ratio? Meaning
The current ratio or working capital ratio is one in which you compare liabilities of a company to its assets, for the debt that needs to pay off within a short period of 12 months. It helps investors and shareholders understand how well the company has performed and whether it is healthy to invest more.
You get to know the overall profits of a business.
Current Ratio Formula:
The formula for calculating the current ratio is:
Current Ratio = Current Assets/ Current Liabilities
To understand the term better, we have an example given below.
Take a company that has the following accounts.
- Cash – $1500
- Securities – $ 2000
- Inventory – $2500
- Debt (short term) – $ 1500
- Payable accounts – $ 1500
Thus, to calculate the current ratio, you will have to consider the current assets versus current liabilities, which is as follows:
Current assets: 1500 + 2000 + 2500 = $ 6000
Current liabilities: 1500 + 1500 = $ 3000
Current ratio = 6000/3000 = 2
You can also calculate this figure quickly by using the free calculator given below:
What is Good Current Ratio?
Now that you know this concept, so let us figure out some more details. What is a better current ratio? If the current ratio is anywhere between 1 and 2, then it is a good current ratio. It says a lot of the business in terms of financial status, and the debt paid off quickly.
Keep one thing in mind, if the number is substantially high, then it is an indication that the business is not managing its funds properly. Something is going wrong in the operation of the company. The margin of having the current ratio between 1 and 2 is variable. It relies on the company and the industry which you are analyzing. However, keeping it in between 1 and 2 is in the best interest of the company.
Why is it Beneficial for a Business?
Through a good current ratio, investors and shareholders would know how liquid the company is and see its financial status in general. Moreover, you could attract investors in the worst-case scenario, those investors might pull out of their investment from your company.
While it is one of the many terms used in knowing how well your company is performing. Furthermore, it is a great indicator to know how well or adverse they have performed in the fiscal year to improve liquidity or increase debts without any difference.
A good current ratio falls in between a tiny margin, which may not give much information and at times gets neglected. Anyways, it’s a great financial tool in knowing how much the company is liable towards achieving short term goals of paying off debt.
Remember, additional information like quick ratio, gross profit ratio, financial profile, etc. would be required to see the overall profitability and debt clearance factor.
Fortunately, it provides a bigger picture of the way the company performs. Not only this, it helps project the success ratio of any short-term goals of a business. So, if you willing to check a company’s short term liquidity, this could be your quick answer.