Current Ratio is the tool to measure the company ability in using current assets to cover the current liabilities. It is the ratio compare between company current assets and current liabilities. The current assets refer to the assets which can be converted to cash within a year. The current liabilities are the liabilities that will be due within the year.

Hight current ratio means that company has strong financial health. The company has enough current assets to pay for the current liabilities. It can prevent the risk of liquidation. A lower ratio means the company does not have enough currents assets to convert to cash to pay for the short-term liabilities. In a serious scenario, it can even lead to the company’s bankruptcy. In order to solve this problem, managements need to seek other sources of funds to settle the liabilities which will be due shortly. sdfdfas

Current Ratio Formula

 $Current\ Ratio = {Current\ Assets \over Current\ Liabilities}$

Advantage of Current Ratio

• Easy calculation: The calculation of current ratio is very simple and straightforward. Almost everyone can do the calculation as long as the company has prepared the financial statements. We simply take the current assets and divide them by the current liabilities.
• Easy Analyze: The current ratio below one, means that the amount of current assets is less than current liabilities, so the company will face a risk when those liabilities are due. If the ratio is greater than one, it means the company is in a good position. They have enough resources to pay for the short-term liabilities.
• Easy to compare: Due to the popularity of current ratio, we are able to compare the ratio from one company to another. It allows the investor to compare the risk from one company to another. It will help them to invest in low-risk company compare to the others in the industry.

Disadvantage of Current Ratio

• Include inventory: The purpose of current ratio is to measure the company’s ability in using current assets to pay for the current liabilities. So the company needs to covert the assets to cash which is may take sometime. The current assets are expected to convert to cash in less than a year. However, the nature of inventory may require more time to convert to cash. The company needs to convert the inventory to accounts receivable before receiving the cash. Some inventories may need more than a year before selling to the customers.
• Seasonal business: It is very hard to use the current ratio to access the company’s financial health if the operation depends on seasonal. We may access the ratio at the end of the year after year-end closing, it will not reflect the business operation during the whole year.
• Not enough to make a conclusion: We cannot rely only on the current ratio to make a conclusion about any company’s financial health. There are many other factors that require to analyze before making a proper decision.
• Easy manipulate: The management may intent to improve this ratio due to various reasons. They may increase the current assets before the year or pay off the current liabilities before the year-end. So it will increase the current ratio.
• Hard to compare: It will not make sense to compare the current ratio from different industries. Some industries have invested a huge amount in working capital while the other industry only invest in the long-term assets.