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What is Current Ratio?

The current ratio is a liquidity ratio that measures the company's ability to meet its short-term requirements.

Obligations due within one year are categorised as short-term requirements.

The current ratio illustrates how a company can efficiently use its current assets to satisfy its current debt and other payables.

The Current Ratio formula is:

Current Ratio = Current Assets/Current Liabilities

Current assets include cash or cash equivalents, receivables, inventory, and other current assets that are expected to convert into cash within one year.

Whereas, current liabilities include account payables, short-term debt, and the current portion of the long term debt.

For an apple-to-apple comparison, the current ratio of a company is typically compared with the average of the industry it operates in.

For instance, the current ratio of a cash generating business like FMCG can't be compared with a high capex defense company.

A current ratio less than the industry's average raises red flags for a higher risk of default.

Similarly, a very high ratio as compared to peers indicates inefficient use of company's assets.

Let's take an example, Company X has Rs 25 m of current assets and Rs 20 m of current liabilities, the current ratio is 1.25.

For every Rs 1 of current debt, Company X has Rs 1.25 of current assets.

What is a 'strong balance sheet'?

Jan 12, 2009

As a stock investor, you may have frequently heard the term 'strong balance sheet'. Investing in companies having a strong balance sheet may be a wise decision, but nonetheless, it is a vague proposition.