The current ratio is a financial ratio that shows the proportion of current assets to current liabilities. The current ratio is used as an indicator of a company's liquidity. In other words, a large amount of current assets in relationship to a small amount of current liabilities provides some assurance that the obligations coming due will be paid.
If a company's current assets amount to $600,000 and its current liabilities are $200,000 the current ratio is 3:1. If the current assets are $600,000 and the current liabilities are $500,000 the current ratio is 1.2:1. Obviously a larger current ratio is better than a smaller ratio. Some people feel that a current ratio that is less than 1:1 indicates insolvency.
It is wise to compare a company's current ratio to that of other companies in the same industry. You are also wise to look at the trend of the current ratio for a given company over time. Is the current ratio improving over time, or is it deteriorating?
The composition of the current assets is also an important factor. If the current assets are predominantly in cash, marketable securities, and collectible accounts receivable, that is more comforting than having the majority of the current assets in slow-moving inventory.