Current assets / Current liabilities
Current assets = Cash
+ short term investments
+ account receivable
+ prepayments and advances
+ other current assets
This ratio is a commonly used measure of short-term solvency : the higher the ratio, the more liquid the company. Nevertheless an excess of current assets over current liabilities does not necessarily mean that debts can be paid promptly. If current assets contain a high proportion of uncollectible or doubtful accounts receivable, or unsaleable inventories, there will be a slow down in cash inflows.
As a result, the current ratio should be analysed together with the nature and proportion of various types of current assets, the nature of current liabilities, the nature of cash flows, the future expectations and the nature of the business itself.
The balance between short-term and long-term debt should also be taken into account : some companies use mostly roll-over short-term debt where others prefer to get long-term funding. The mix between short and long-term debt will affect the current ratio as far as current liabilities are concerned.
The current ratio and similar measures of solvency are key indicators for many businesses. Along with the improvement of stock and inventory management (just in time delivery, CRM-based organisation, etc), companies tend to develop aggressive financial management policies resulting in a higher level of trade creditors and a tightening grip on trade debtors.
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