CURRENT RATIO

Description: The current ratio is used by lenders to determine whether a company has a sufficient level of liquidity to pay its liabilities. A current ratio of 1:1 is considered to be the absolute minimum level of acceptable liquidity, whereas a ratio closer to 2:1 is preferred.

Formula: Divide all current assets by all current liabilities. The formula is:

Example: A prospective purchaser is interested in the current financial health of the Ginseng Plus retail chain, which sells herbal remedies for common maladies. The purchaser obtains the information in Table 5.6 about the company for the past three years.

TABLE 5.6

The rapid increase in the amount of current assets indicates that the retail chain has probably gone through a rapid expansion over the past few years. The sudden jump in current liabilities in the last year is particularly disturbing and is indicative of the company suddenly being unable to pay its accounts payable, which have correspondingly ballooned. The purchaser elects to reduce the offer for the company because of the likely prospect of an additional cash infusion to bring its operations onto an even keel.