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A company needs to have enough liquidity to meet its short-term financial obligations or else it won't be successful. The current ratio is an accounting metric that provides one measure of liquidity. Defined as a company's current assets divided by its current liabilities, the current ratio shows you whether the company has enough liquidity to pay what it owes. Higher current ratios tend to be better than low current ratios, but having a figure that's too high can indicate inefficient use of financial resources.
Understanding the current ratio
To fully understand the current ratio, you need to know what current assets and current liabilities are. Current assets include assets that are relatively easy to convert into cash within a short period of time. Accountants often use one year as the dividing line in determining liquidity. On the balance sheet, cash and short-term investments are the most obvious current assets. Others include accounts receivable, which the company can collect on within a short period of time, and inventory, which the company can sell to generate cash. Marketable securities are also current assets even if they're technically long-term investments because they can be liquidated, albeit not necessarily at an ideal price.
Similarly, current liabilities are what a company owes to third parties like suppliers and creditors. Again, accountants use a one-year time horizon in acknowledging the short-term nature of current liabilities. Current liabilities include accounts payable, accrued expenses that haven't yet been paid, income tax liability, short-term notes, and whatever portion of long-term debt is due within the next year.
How to use the current ratio
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Current ratios provide a simple look at a company's liquidity. A current ratio below 1 shows that the company's short-term financial resources are inadequate to cover immediate expenses, and that suggests that additional capital will be necessary to keep the business running. Current ratios of 1.5 or greater are generally enough to meet operating needs well. Ratios that are extremely high suggest that a company is hoarding assets that aren't strictly necessary, and you'll want to look closely to make sure that the company is being efficient in keeping those assets on its books rather than using available cash and liquid assets for other purposes.
Keep in mind that even if one company's current ratio is the same as another's, that doesn't mean that they're necessarily equally solid. In particular, the type of current assets makes a huge difference in financial strength. A company that has most of its current assets in cash will have no problem paying off near-term obligations. On the other hand, a company with current assets primarily in inventory and accounts receivable will have to take action to sell its products and collect on what its customers owe in order to generate the cash to pay its debts.
Despite these concerns, the current ratio is a good gauge to offer a simple look at a company's finances. Using current ratios to compare companies in the same industry can be a good way to assess whether one company is more financially secure than another in the short term.
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