IGCSE Accounting 0452 - 6.1 Current Ratio

This section explains the current ratio, a key financial ratio used to assess a company's ability to pay off its short-term liabilities with its short-term assets.

What is the Current Ratio?

The current ratio is a liquidity ratio that measures a company's ability to meet its short-term obligations using its current assets. It indicates whether a company has enough liquid assets to cover its immediate debts.

Formula

The formula for calculating the current ratio is:

$$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} $$

Where:

• Current Assets: These are assets that can be converted into cash within one year. Examples include cash, accounts receivable, and inventory.
• Current Liabilities: These are liabilities that are due within one year. Examples include accounts payable, salaries payable, and short-term loans.

Understanding the Current Ratio

The current ratio is typically interpreted as follows:

• Current Ratio > 1: This generally indicates that the company has more current assets than current liabilities, suggesting a good ability to pay off its short-term debts.
• Current Ratio = 1: This means the company has an equal amount of current assets and current liabilities. It might be acceptable, but could indicate a tight financial position.
• Current Ratio < 1: This suggests that the company has fewer current assets than current liabilities, potentially indicating difficulty in meeting short-term obligations.

Important Note: A "good" current ratio can vary depending on the industry. Some industries naturally have lower current ratios than others.

Example Calculation

Consider a company with the following figures:

• Current Assets = $50,000
• Current Liabilities = $25,000

Using the formula:

$$ \text{Current Ratio} = \frac{50,000}{25,000} = 2 $$

In this case, the current ratio is 2. This suggests that for every $1 of current liabilities, the company has $2 of current assets, indicating a strong ability to pay off its short-term debts.

Table Summary

Ratio	Formula	Interpretation
Current Ratio	$$ \frac{\text{Current Assets}}{\text{Current Liabilities}} $$	Indicates the company's ability to pay off its short-term liabilities with its short-term assets.

Figure: Suggested diagram: A simple bar chart showing a current ratio of 1.5 labeled as "Good Liquidity".