What is the current ratio and how is it interpreted?

• A. Current assets divided by current liabilities; a ratio above 1 indicates short-term liquidity.
• B. Current liabilities divided by current assets; a ratio above 1 indicates liquidity risk.
• C. Net working capital divided by current assets; a ratio above 1 indicates profitability.
• D. Gross profit divided by current assets; a ratio above 1 indicates efficient operations.

Answer: (A)

The current ratio is a measure of short-term liquidity. It compares what a company has that can be turned into cash within a year (current assets) to what it owes within that same period (current liabilities). You calculate it by dividing current assets by current liabilities. When the ratio is above 1, the company generally has enough near-term assets to cover its near-term obligations, signaling good liquidity. If it’s below 1, there’s a nearer-term liquidity risk because liabilities exceed readily available assets. Keep in mind, a very high ratio can also suggest underutilized resources, like excess cash or inventory, rather than optimal working capital.