Current ratio
Topic 6.1: Calculation and Understanding of Accounting Ratios
Current Ratio
The current ratio measures a company's ability to pay its short‑term debts using its short‑term assets. Think of it as a “cash‑on‑hand” check: how many dollars of liquid assets do you have for every dollar of short‑term obligations?
Formula
$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$
Where:
- Current Assets = Cash + Accounts Receivable + Inventory + Other short‑term assets
- Current Liabilities = Accounts Payable + Short‑term debt + Other obligations due within 12 months
Analogy
Imagine you’re planning a road trip. Current assets are the fuel and snacks you have in the car. Current liabilities are the tolls and parking fees you expect to pay along the route. A higher ratio means you have plenty of fuel to cover all the tolls.
Example Calculation
| Item | Amount (£) |
|---|---|
| Cash | 12,000 |
| Accounts Receivable | 8,000 |
| Inventory | 15,000 |
| Other Current Assets | 3,000 |
| Total Current Assets | 38,000 |
| Accounts Payable | 10,000 |
| Short‑term Debt | 5,000 |
| Other Current Liabilities | 3,000 |
| Total Current Liabilities | 18,000 |
Now calculate the ratio:
$$\text{Current Ratio} = \frac{38,000}{18,000} \approx 2.11$$
Interpretation
A ratio of 2.11 means the company has £2.11 of current assets for every £1 of current liabilities. Generally:
- Less than 1 – Not enough short‑term assets to cover liabilities (risk of liquidity problems).
- 1–2 – Adequate liquidity; the company can comfortably meet short‑term obligations.
- Greater than 2 – Very good liquidity; the company has a cushion, but may be tying up too much capital in current assets.
Exam Tips
- Always identify the items that belong in current assets and current liabilities.
- Show the calculation step‑by‑step – examiners look for the formula.
- Use the ratio to comment on liquidity – give a brief interpretation.
- Check for unit consistency (e.g., all amounts in £).
- Remember that a ratio > 1 is generally good, but too high may indicate inefficient use of assets.
Practice Questions
- Company X has the following figures (in £):
Current assets: £25,000
Current liabilities: £10,000
Calculate the current ratio and state whether the company has good liquidity. - Explain why a current ratio of 0.8 would be a red flag for a business.
- Given a current ratio of 1.5, suggest one way the company could improve its liquidity.
Good luck, and remember: the current ratio is your “liquidity health check” – keep it above 1 and you’re on solid ground! 🚀
Revision
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