A company should be able to know its short-term liquidity. In accounting, one measurement standard can determine the company’s short-term liquidity. This measurement standard is the current ratio. With it the company’s management will determine the cash flow strategy that the company can do in facing liquidity problems. So, how to calculate the current ratio? This article will provide information for readers about formulas to calculate it.
Current Ratio Definition
The current ratio is a standard for measuring a company’s short-term liquidity while considering the available assets and liabilities. In other words, the current ratio can be a tool to find out how the company can pay all its debts. Current ratios can help the company’s management determine the next cash flow strategy in overcoming liquidity problems that occur.
Current Ratio Formula
To know the current ratio, there is a calculation formula that you can use. Here is the calculation formula:
Current Ratio = Current Assets / Current Liabilities
According to Scale Factor, current assets refer to everything that your company possesses that could be liquidated or turned into cash within one year. Meanwhile, current liabilities include any expenses that will be paid out in the next year, such as accounts payable, payroll, credit cards, and sales tax payable.
Current Ratio Calculation Example
A company has current asset balances and current liabilities recorded in its financial position statement for the year ended December 31, 2020.
Cash and Cash Equivalents: 30,000,000
Accounts Receivables: 150,000,000
Other Current Assets: 100,000,000
Account Debt: 25,000,000
Current Tax Debt: 140,000,000
Accrual Expense: 150,000,000
So, what is the current ratio of the company? Check out the following explanation to find out the answer:
Total Current Assets: 480,000,000
Total Current Liabilities: 405,000,0000
Current Ratio: 1.2 (480,000,000 / 405,000,000)
Correlation between Current Ratio and Debt
The current assets will be divided by current liabilities or debt in calculating the current ratio. This calculation will show the inverse correlation between the company’s current debt level and the measurement. As the company takes on more short-term debt, the ratio will decrease. And as it pays off more short-term debt, the measurement will increase.
Distinctions between Current Ratio and Other Liquidity Ratios
For information, there are three primary liquidity ratios, namely current, fast and cash ratio. The presence of these three ratios can help in measuring how liquid a company is. Liquid, in this case, refers to the company’s ability to meet its short-term debt using currently available assets. However, you need to know that each calculation is slightly different. The current ratio can be determined by dividing current assets with current liabilities. Meanwhile, a quick ratio is an inventory of current assets divided by current liabilities. Then, the cash type is cash and cash equivalents or current liabilities.
Current Ratios Limitations
The presence of the current ratio provides convenience for a company in knowing the company’s liquidity. However, this does not cover up all. If you want to know the whole company’s financial health conditions, it’s important for you to look at more than just the company’s current assets and liabilities. For example, Walmart supermarkets had a current ratio below one at the end of Fiscal 2018. In this case, Walmart is not profitable or has risks of going out of business. The case is cited from Walmart’s 2018 Annual Report.
Another limitation in this type is unethical to compare companies across industries. For example, business industries that tend to carry a lot of inventory often result in higher current ratios. However, this does not mean that the company can pay off the company’s short-term debt.
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As one of the accounting measurement standards, the current ratio has several functions for a company. It can help the company’s management determine the cash flow strategy that the company will take in facing the liquidity problems. Not only that, but it can be a tool for companies to find out whether the current assets that the company has can pay off current liabilities or not. Speaking of accounting, you can automate various company’s accounting activities easily using HashMicro’s Accounting System. This system comes with the best features. Contact us now to get the best deals and free demos!