Current Ratio : An important Liquidity Ratio
One of the most common reasons why liquidity is important for a business is to make payments and to meet current and/or regular cash needs.
Liquidity refers to the ability of a company to meet its current obligations as and when they become due. It is one of the most essential factors responsible for a business's smooth running.
A liquidity ratio measures the shortterm solvency of any firm. One such liquidity ratio is the Current Ratio. The current ratio compares a company's current assets to its current liabilities. So, let's understand the current ratio in detail.
What is the Current Ratio?
A Current Ratio is the liquidity ratio with which we can identify a company's ability to pay its shortterm obligations or those that are to be due within one year. It is the most common ratio that financial analysts widely use.
A current ratio can tell us the shortterm financial position of a company. This ratio is also called the 'Working Capital Ratio'. It tells us the relationship between Current Assets and Current Liabilities.
Calculation of Current Ratio
Calculating the current ratio involves comparing a company's current assets to its current liabilities. We can find a company's current assets and current liabilities on its Balance Sheet. The formula for calculating a current ratio is as follows:
Current Ratio = Current Assets ÷ Current Liabilities
 Current assets include cash and those assets which can be easily converted into cash in a short period of time or one year, such as Shortterm Investments, Debtors, B/R, Stock, Prepaid Expenses etc.
 Current liabilities include obligations payable within one year, such as Creditors, B/P, Taxes, Dividends payable, etc.
The Ideal Level: The ideal Current Ratio is considered to be 2:1. This ratio can be considered safe and conservative because even if the current assets get reduced to half, the company will also be able to clear off its shortterm debts and liabilities.
While calculating a company's current ratio, we must compare it with the current ratio of its peer companies or companies involved in the same line of business.
A current ratio that is on average to the industry or slightly higher is considered to be good and eligible for further analysis. A current ratio that is lower than the industry average makes it nonacceptable and indicates risk. A very high current ratio indicates that a company cannot utilize its assets efficiently.
How to use a Current Ratio
Let us see how to use the current ratio while analyzing a company for investment. Assume that A, B, and C are three companies with the same kind of business as our competitors. By reading the Balance Sheet of all the three companies, we get the following information:
Company 
Current Assets 
Current Liabilities 
Current Ratio 
A 
125 crores 
100 crores 
1.25 
B 
25 crores 
30 crores 
0.83 
C 
30 crores 
31 crores 
0.96 
Now looking at this table, we find that company A has a current ratio of 1.25, meaning that for every 1 rupee of debt (short term), company A has 1.25 rupees of assets to clear its obligations.
Similarly, company B has 0.83 rupees of assets to clear its debt of 1 rupee and company C has 0.96 rupees of assets to clear its debt of 1 rupee. Thus, company A has enough assets which can be converted into cash to meet its shortterm obligations.
A case study on Reliance Industries
The data below is obtained from the Balance Sheet of the company for the financial year ended in March 2020:
Particulars 
Amount in Crores 
Current Assets 

Short Term Investments 
72,915 
Inventories 
73,903 
Sundry Debtors 
19,656 
Cash & Bank 
30,920 
Others 
60,866 
Total Current Assets 
2,58,260 crores 
Current Liabilities 

Short Term Borrowings 
93,786 
Short Term Trade Pay 
96,799 
Other S.T. Liabilities 
2,20,441 
Short Term Provisions 
1,890 
Total Current Liabilities 
4,12,916 Crores 
According to the formula of the Current Ratio, we have:
Current Ratio 
2,58,260 ÷ 4,12,916 = 0.62 
As we can see that the current ratio of Reliance Industries was 0.62. It shows that there were not enough current assets in this company to clear off its short term debts.
But it does not completely mean that it is not worth investing. There are several other parameters that can indicate whether the company is good to invest in or not.
As a matter of fact, it was also seen that Reliance Industries got many large Institutional Investors for their company, e.g., Facebook, Silver Lake etc.
All these investments in Reliance Industries helped to clear its debt. And now, Reliance is on the verge of becoming a debtfree company. Moreover, during March, its P/E ratio was 18, which tells us that at that time, it was undervalued and was a good option for investment.
*Disclaimer: This is not a recommendation either to buy or sell. It is for educational purposes only.
Importance of Current Ratio
 This ratio is used by creditors to evaluate whether a company can be offered shortterm debts.
 It also provides information about the company's operating cycle.
 It shows a company's ability to convert its assets into cash to pay off its shortterm liabilities.
Limitations of Current Ratio
While using the current ratio for analyzing a company for investment purposes, the following limitations must be kept in mind:
 The current ratio only tells us the quantity of assets and not the quality of assets.
 A current ratio can be easily manipulated by overvaluing the current assets.
 A current ratio cannot tell whether a company is receiving timely payments from its customers.
 Several liabilities can also be neglected for just representing a good current ratio.
The Bottom Line
As important as the current ratio is for analyzing a company's financial health, one should not make a solid assumption about its investment worth. A company with a current ratio of 2 or above does not always mean that it is a good company to invest in.
Moreover, it is not necessary that a current ratio always represents a company's complete liquidity or solvency. There are certain other factors also that are equally important while analyzing a company.
When analyzing a company for an investment opportunity, we must prioritise the quality of assets over the quantity of assets. Ultimately, it is important to remember that no single financial figure or ratio can be the sole parameter for defining its financial health and investment worth.
Such decisions must be taken, considering all possible factors and looking at the company from all different angles. Only then, can the investment be utilized to its fullest potential.