The current ratio used to measure the firm ability to pay off its short term debts. It is a form of liquidity and efficiency ratio. It is like to be the essential version of Liquidity ratio because there is a need to measure to current firm ability to clear off their short term loans within a year.
It usually means the firm has less time to clear off the debts and the best measure to calculate current ratio is by checking the existing assets of a company which can be easily converted into the cash later, Such as, cash equivalent, market securities, etc.
Current Ratio Formula:
The formula which use to examine the ratio of current liabilities and the current assets of a company. It usually for measuring the exact financial state of the firm. The formula for calculating the current ratio is current assets divides by current liabilities.
The mathematical formula as follows:
Current Ratio = Current Assets/Current Liabilities.
Note: GAAP requires that the company should separate their current assets and fixed assets in their balance sheets to not make any confusions.
The current ratio does help the company investor and creditors example bank to comply with the financial state of the firm. This is to check out whether they can able to clear off their short term debts or not. The ratio expresses the current rate of firm assets and the liabilities owed by the company.
The higher ratio of the company is more preferable rather than a lower current ratio of the firm. It is because of the higher ratio results in getting the best financial state of the company. It means the company can quickly pay off the debts.
However, if the company needs to sell out its fixed assets for clearing short term debts, it simply means the firm is not making enough from the current operations of the company. Meanwhile, It is going in the loss.
Let me show you by example:
Charlie’s balance sheet he reported $100,000 of current liabilities and only $25,000 of current assets. Charlie’s current ratio would be calculated like this:
Current Ratio = Current Assets/Current Liabilities
Current Ratio = 25000/100000
Current Ratio = .25
It means the business of charlie is at higher risks. Because the ratio of charlie business is only .25% to clear off his debts by selling out the current assets, the bank more likely to prefer the current ratio of 1 or 2 so, that the liabilities should be covered by selling of the assets and meanwhile, charlie not approved for the loan.
The current ratio is the liquidity calculation for any business. It often used for measuring the financial position of the company. You can check out the example above where we showed the condition of charlie, and he has only .25% chance to pay off his debts. In this case, the bank will not pass your loan.
Therefore, It is essential to make a better ratio to ensure that your loan should not be rejected.