Investing for Beginners , investing

Current ratio is a financial ratio that measures company’s financial liquidity in short term. In simple words, this ratio compares company’s short-term assets to its short term liabilities. If short-term liabilities are higher than short-term assets (which means current ratio is less than 1.0), it might indicate that company is exposed to financial liquidity related risks. 

Higher current ratio means higher financial liquidity of a company. If this ratio is higher than 2.0, company may feel safe about liquidity over short-term period. However, very high current ratio might indicate another problem: if this ratio is high, it means that company has a lot of working capital which may lead to inefficient management of working capital. 

The ratio is one of useful tools to assess company’s financial liquidity, but the main problem is the difference between the real market value and book value of current assets. Especially in a period of financial crisis, the real value of assets can be lower than the book value in balance sheet. 

However, company’s financial liquidity should not be mixed with company’s solvency. Even strong companies may face liquidity problems during financial crisis when banks are cutting financing. Such liquidity problems might be fatal for weaker companies. 

In financial practice other liquidity ratios usually are used together with ‘current ratio’:

• Quick ratio
• Cash ratio