Q&A - How is the current ratio calculated and interpreted?
The current ratio is the classic measure of liquidity. It indicates whether the business can pay debts due within one year out of the current assets. The current ratio reveals how much “cover” the business has for every £1 that is owed by the firm. For example, a ratio of 1.5:1 would mean that a business has £1.50 of current assets for every £1 of current liabilities.
An example of this calculation is shown below:
The calculation can be illustrated as follows:
At 31 December 2010 current assets were 1.85 times the value of current liabilities. That ratio was more than the 1.7 times at the end of 2009, suggesting a slight improvement in the current ratio.
A current ratio of around 1.7-2.0 is pretty encouraging for a business. It suggests that the business has enough cash to be able to pay its debts, but not too much finance tied up in current assets which could be reinvested or distributed to shareholders.
A low current ratio (say less than 1.0-1.5 might suggest that the business is not well placed to pay its debts. It might be required to raise extra finance or extend the time it takes to pay creditors.
There is no such thing as an ideal current ratio (a good point to make in an exam). Different businesses and industries work with different levels of cover. However, a ratio of less than one is often a cause for concern, particularly if it persists for any length of time.
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