How to calculate the current ratio from the balance sheet
The current ratio is a crucial financial metric used by businesses, investors, and lenders to determine a company’s financial health. It provides essential insight into the liquidity and working capital position of a company, enabling stakeholders to make informed decisions. In this article, we will guide you on how to calculate the current ratio from a balance sheet.
What is Current ratio?
The current ratio is a liquidity ratio that measures a company’s ability to repay its short-term debts using its short-term assets. It establishes the relationship between current assets and current liabilities. A higher current ratio indicates that a company has more liquid assets than short-term liabilities, implying financial stability.
Current Ratio Formula:
To calculate the current ratio, divide the total value of current assets by the total value of current liabilities.
Current Ratio = Current Assets / Current Liabilities
Step by Step Guide on Calculating Current Ratio:
Step 1: Identify Current Assets
Refer to the company’s balance sheet and locate the “current assets” section, which usually includes cash, accounts receivable, inventory, short-term investments, and other temporary or liquid assets within one year.
Step 2: Calculate Total Current Assets
Sum up all individual items listed under current assets.
Total Current Assets = Cash + Accounts Receivable + Inventory + Short-term Investments + Other Liquid Assets
Step 3: Identify Current Liabilities
On the balance sheet, locate the “current liabilities” section. These are obligations that must be settled within one year. Common items include accounts payable, short-term debt, accrued expenses, and other short-term liabilities.
Step 4: Calculate Total Current Liabilities
Add up all individual items listed under current liabilities.
Total Current Liabilities = Accounts Payable + Short-Term Debt + Accrued Expenses + Other Short-Term Liabilities
Step 5: Compute the Current Ratio
Use the formula mentioned above to calculate the current ratio, dividing total current assets by total current liabilities.
Example:
Let us calculate the current ratio for a hypothetical company with the following balance sheet data:
Current Assets:
Cash: $100,000
Accounts Receivable: $75,000
Inventory: $50,000
Short-term Investments: $25,000
Current Liabilities:
Accounts Payable: $80,000
Short-Term Debt: $10,000
Accrued Expenses: $20,000
Total Current Assets = $100,000 + $75,000 + $50,000 + $25,000 = $250,000
Total Current Liabilities = $80,000 + $10,000 + $20,000 = $110,000
Current Ratio = Total Current Assets / Total Current Liabilities = 250,000 / 110,000 = 2.27
This company’s current ratio is 2.27, indicating that it has $2.27 in current assets available for every dollar of its current liabilities.
Conclusion:
Understanding how to calculate the current ratio from a balance sheet enables stakeholders to monitor the financial well-being of a company at regular intervals. A higher-than-industry-average current ratio usually suggests good liquidity; however, too high of a ratio may indicate inefficient use of funds. It is vital to monitor changes in the value over time and compare it with industry averages to gauge a firm’s liquidity position accurately.