The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off its short-term liabilities with its current assets. The current ratio is an important measure of liquidity because short-term liabilities are due within the next year.
Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that companies with larger amounts of current assets will more easily be able to pay off current liabilities when they become due without having to sell off long-term, revenue generating assets.
- Analyst can use liquidity ratios to quickly screen a large number of companies for potential problems.
- Can be distorted via creative accounting practices
The current ratio helps investors and creditors understand the liquidity of a company and how easily that company will be able to pay off its current liabilities. This ratio expresses a firm’s current debt in terms of current assets. So a current ratio of 2.5 would mean that the company has 2.5 times more current assets than current liabilities.
A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make current debt payments (<1 year).
The current ratio also sheds light on the overall debt burden of the company. If a company is weighted down with a current debt, its cash flow will suffer.