Current ratio: Overview, definition, and example
What is current ratio?
The current ratio is a financial metric that shows a company’s ability to pay its short-term obligations using its short-term assets. It’s calculated by dividing current assets (like cash, inventory, and accounts receivable) by current liabilities (like bills, short-term loans, and payroll). The result is a simple number that helps assess liquidity and short-term financial health.
Why is current ratio important?
The current ratio helps lenders, investors, and partners understand whether a company can meet its short-term financial obligations without running into cash flow problems. A low ratio may signal potential trouble, while a very high ratio might suggest inefficient use of assets. In loan agreements or investment deals, a minimum current ratio is often required to reduce financial risk.
Understanding current ratio through an example
If a company has $200,000 in current assets and $100,000 in current liabilities, its current ratio is 2.0—meaning it has $2 in liquid assets for every $1 it owes in the near term. But if that ratio drops below 1.0, it could mean the business might struggle to pay its upcoming bills unless it raises more funds or collects outstanding payments quickly.
Example of a current ratio clause
Here’s how a current ratio clause may appear in a contract:
"The Borrower shall maintain a minimum current ratio of 1.25:1 at all times during the term of this Agreement, measured on a quarterly basis using GAAP-compliant financial statements."
Conclusion
The current ratio is a quick way to check a company’s short-term financial health. It’s often used in loan agreements or financial covenants to provide assurance that the business can meet its immediate obligations. Businesses should monitor their current ratio regularly to maintain credibility and avoid breaching contract terms.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.