What is the Current Ratio?

The Current Ratio = Current Assets/Current Liabilities

Current is defined as assets and liabilities that will be received or paid within the next 12 months or operating cycle.

The ratio is used to give an idea of the company’s ability to pay back its short term
Liabilities(debt and payables) with its short-term assets ( cash, inventory,and receivables).
The standard that most outside users of the financials look for is a ratio of 2 to 1.

The major limitation of the ratio is that you include both receivables and inventory in the calculation of Current Assets. It would seem to me that you would want to back out receivables more than 90 days old and inventory that is obsolete, slow moving, not selling, etc, in order to get a more realistic Current Ratio.

How Can Ratio Analysis Help My Company?

Ratio Analysis is the use of your accounting information to help you become aware of potential problems and also to see how you compare to your industry ratios.  In this economy, successful companies are the ones who can use their accounting information to see who their best customers are, which products are most profitable and if there are any danger signs ahead, such as lack of cash.

The ratios are grouped into four categories, Profitability, Activity, Leverage and Liquidity. Profitability tells you how well you are doing. As with all Ratio Analysis, it is critical that you have some industry statistics, so that you can see how your company's performance compares with your peers.

Activity Ratios tell you the quality of your Accounts Receivable and your Accounts Payable.

Leverage Ratios tell you how well you are managing debt and Liquidity Ratios warn you if it looks like you will have trouble paying your current bills in the future.

In later posts, I will talk about Ratio Analysis in greater detail. However, needless to say, in order to take advantage of Ratio Analysis, it is critical that your accounting information be accurate.