How is the current ratio calculated and what does it indicate?

How is the current ratio calculated and what does it indicate?

• A. Current Ratio = Current Assets / Current Liabilities; indicates short-term liquidity.
• B. Current Ratio = Total Liabilities / Total Assets; indicates long-term solvency.
• C. Current Ratio = Net Revenue / Operating Expenses; indicates profitability.
• D. Current Ratio = Inventory / Cost of Goods Sold; indicates turnover.

Answer: (A)

The key idea is short‑term liquidity—how well a company can meet its near‑term obligations using assets that are expected to be converted to cash within a year. The current ratio is calculated by dividing current assets by current liabilities. Current assets include items like cash, accounts receivable, and inventory that will be turned into cash soon. Current liabilities are obligations due within a year, such as accounts payable and short‑term debt. If the ratio is greater than 1, there are more current assets than current liabilities, signaling a cushion to cover short‑term bills; a higher ratio often suggests stronger liquidity, though it isn’t a guarantee of healthy cash flow or efficient use of assets. Conversely, a ratio below 1 indicates potential liquidity pressure. Other formulas shown belong to different financial concepts: one measures long‑term solvency by comparing total liabilities to total assets; another represents profitability by relating net revenue to operating expenses; and another is not a standard measure of turnover, since inventory turnover is typically COGS divided by average inventory.

The key idea is short‑term liquidity—how well a company can meet its near‑term obligations using assets that are expected to be converted to cash within a year. The current ratio is calculated by dividing current assets by current liabilities. Current assets include items like cash, accounts receivable, and inventory that will be turned into cash soon. Current liabilities are obligations due within a year, such as accounts payable and short‑term debt. If the ratio is greater than 1, there are more current assets than current liabilities, signaling a cushion to cover short‑term bills; a higher ratio often suggests stronger liquidity, though it isn’t a guarantee of healthy cash flow or efficient use of assets. Conversely, a ratio below 1 indicates potential liquidity pressure.

Other formulas shown belong to different financial concepts: one measures long‑term solvency by comparing total liabilities to total assets; another represents profitability by relating net revenue to operating expenses; and another is not a standard measure of turnover, since inventory turnover is typically COGS divided by average inventory.