Investment Formula Description
Current Ratio is an investment formula and indicator to reflect the ability of a corporation to return short term debt obligations by using its current assets.
This investment formula is used to measure liquidity of a corporation to pay off its current liabilities ( debt and payables ) with its current assets (cash, inventory, receivables) . Hence, it is sometimes referred as working capital ratio, liquidity ratio, cash asset ratio or even cash ratio.The higher the current ratio, the more capable the corporation is able to pay off its debt obligations when they came due at that point. Current ratio for different industry corporations can be vary in high range. For examples, IT corporation tends to have higher current ratio compared to manufacturer.The appropriate way for comparison between two current ratio is to compare with the competitors instead of other corporations in other industry. For conservative measurement, a healthy corporation in financial perspective should have a least 2 point of current ratio, which means current assets are 2 times higher than current liabilities.For those corporations that have current ratio less than 1, this kind of corporation might face financial crisis if it is requested to clear all the current liabilities at one shot. Besides, there isanother liquidity formula that is more conservative than current ratio. It is named as quick ratio or acid test ratio.
Investment Formula Example
If Corporation A has total $ 2,000,000 of current assets and $1,000,000 of current liabilities,
Current Ratio or Liquidity Ratio = Current Assets / Current Liabilities = 2,000,000 / 1,000,000 = 2.
Corporation A has 2 times of current ratio. In a financial crisis, even corporation A is requested to return all the current liabilities, the calculation of remaining assets after paying off all the debts as following.
Total Remaining Assets = Current Assets - Current Liabilities = 2,000,000 - 1,000,000 = 1,000,000
Corporation A will still have $1,000,000 current asset to run its business after paying off all the debts and current liabilities. Hence, Corporation A is healthy in term of liquidity.