4.5 : Liquidity Ratios: Current Ratio

Liquidity management involves strategically acquiring and using cash or near-cash resources, such as marketable securities, treasury bills, or short-term deposits, to ensure the company can meet its cash obligations as they come due.

The current ratio, calculated by dividing current assets by current liabilities, is a valuable tool for evaluating a company's liquidity.

Current assets are resources that can be quickly converted into cash, typically within a year. These include cash, cash equivalents (highly liquid investments with maturity of up to 90 days, such as government securities), marketable securities maturing in under a year, accounts receivable, inventory, and prepaid expenses.

Current liabilities are obligations a company owes to suppliers and creditors that are due within a year. These include notes payable (interest and loan principal due within the next year), accounts payable, accrued expenses, and deferred revenue (payments received for services or goods that will be delivered in the future once revenue recognition criteria are met).

For instance, consider a retail company with $250,000 in current assets, including cash, inventory, and accounts receivable, and $125,000 in current liabilities, such as short-term loans and accounts payable. This gives the company a current ratio of 2:1, meaning it has $2 in current assets for every $1 in current liabilities, indicating strong liquidity and the ability to cover its short-term obligations.