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.