Current ratio also referred to the liquidity ratio as the main aim of this ratio is to determine the capability of the company to pay both short-term and long-term obligations.
To derive the rate, it needs to take into account the current total assets of the enterprise, which can include both liquid and illiquid assets and hence they should put it about the current total liabilities of the company.
The reason it is called the present is that it considers all the current assets and liabilities and does not take into account the history of any company or business. Hence the formula that can be used to calculate the current ratio is mentioned below:
Current Ratio = Current Assets/Current Liabilities
Understanding the Concept of Current Ratio in Detail
The financial analysts can get an idea of the current ratio of a company that what is the ability of the company regarding paying back the liabilities and assets. Hence it can be used to depict the overall financial health of any business.
If the ratio is high then this means that the company can pay all of its obligations on time, however; if the current ratio is low, then this means that the financial health of the company is not suitable enough to pay off the obligations and all debts on time.
If the current ratio of any company is less than one, then this means that the liabilities of the business are more significant than the assets of the business hence the business or the business might not be able to pay off its dues and obligations.
However, if the ratio is above that one, then this means that the financial health of the company is stable. In case the ratio is above three then this is not to say that the corporation is operating entirely, in fact, it means that the assets of the company are not used efficiently and neither the company is managing its capital in a balanced manner.
Hence to create a better assessment of the issues that are present, the liquidity ratio of the enterprise needs to be more accurate as compared to the current ratio.
What are the limitations of the Current Ratio?
There are some limitations to the concept of current ratio, and hence they can have an impact on the assessment of the company’s financial health. One of the limitations of current rate comes up when a comparison is being made to one ratio with the ratio of other competing firms.
The business operations of every company are different and every company operates differently hence a comparison of a group with any other company might not give accurate insights. The idea of current ratio is helpful if the companies were working and dealing, in the same manner, are compared with one another.
Another limitation is that the current ratio includes all the aspects of a company, which includes the company’s current assets thus it also provides the property that cannot be liquidated quickly. Thus such factors might not help people in determining whether the company is operating and functioning efficiently and whether they can pay off their debts and obligations on time.
Current ratios are not the only ratios that fall under the category of liquidity ratios. There are other ratios as well that can help determine the health of the company. However, when the current ratio of any business needs to be considered, then its relationship with other liquidity ratios should also be found.