Learn: Current Ratio - Calculation and Interpretation

Welcome!You've already learned about key financial concepts such as working capital, balance sheets, and ROCE. Today, we'll build on that by exploring the current ratio, an important tool for assessing a business's liquidity.

What is the Current Ratio?The current ratio is a financial measure that shows a business's ability to pay its short-term debts using its short-term assets. It's important because it helps assess whether a business has enough resources to meet its obligations.

How Is the Current Ratio Calculated?The formula for the current ratio is:Current Ratio = Current Assets ÷ Current LiabilitiesThis means you divide the total value of current assets (e.g., cash, inventory, receivables) by the total value of current liabilities (e.g., trade payables, short-term loans).

Why Is the Current Ratio Important?A healthy current ratio indicates that a business can cover its short-term debts with its short-term assets. For example, a ratio of 2:1 means the business has £2 in current assets for every £1 of current liabilities.

Interpreting the Current RatioA ratio higher than 1 indicates the business has more assets than liabilities, which is generally positive. However, if the ratio is too high, it could mean the business is not using its resources efficiently.

What Is a 'Good' Current Ratio?While the ideal current ratio depends on the industry, a ratio between 1.5 and 2 is generally considered healthy. A ratio below 1 may indicate financial difficulty, while a very high ratio might suggest inefficiency in using assets.

Review Time!Great work! You've learned how to calculate and interpret the current ratio. Let's review everything with a few final questions.

Congratulations!You now understand current ratio calculation and interpretation. Use this knowledge to analyse liquidity in real-world business scenarios!