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The current ratio is a simple but effective tool that is often used to get an accurate picture of the financial stability of a company. Essentially, the calculation of a current ratio only requires that access to two accurate pieces of information is present – the total of current liabilities held by the company, as well as the value of current assets. By comparing the two figures and arriving at the current ratio for the company, it is possible to plan for future operations and determine ways to improve the overall condition of the business.
One of the most important facts that a current ratio will reveal is the current status of a company to honor short-term debt obligations. Generally, a company that is in good financial condition will have a high ratio of assets to liabilities. This means that the company will not anticipate any problems in being able to honor short-term debt that may have been acquired to enhance some portion of the production process or replace equipment.
Sometimes referred to as a working capital ratio, the simple formula of dividing liabilities by assets can also make it possible to become aware of a situation where the company is not as secure as it should be. While the company may in fact be meeting its obligations on time, a lower current ratio indicates that net profits are low and that some changes are in order, if the company wants to remain solvent over the long term. Thus, a low current ratio can be a wakeup call to begin refining the use of available resources, improve the efficiency of the general operation, and possibly eliminate restructure some departments so that necessary tasks are performed with less cost incurred.
Companies tend to employ the current ratio strategy on a regular basis. In more volatile industries, corporations may choose to calculate a current ratio each billing period or at least every calendar quarter. For companies that are engaged in a relatively stable industry, they may find that a semi-annual current ratio works well. Of course, a current ratio can be calculated at any time, as long as a specific date for evaluating the status of both assets and liabilities is identified.
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