How do you calculate the current ratio and what does a higher ratio indicate about liquidity?

• A. Gross margin divided by current liabilities
• B. Current ratio = Current assets / Current liabilities
• C. Net income divided by current assets
• D. Current liabilities divided by current assets

Answer: (D)

The main idea is liquidity—how easily a company can meet its short-term obligations with assets expected to be converted to cash within a year. The current ratio is calculated by dividing current assets by current liabilities. This shows how many dollars of current assets the firm has for every dollar of current liabilities. A higher ratio means more cushion to cover near-term debts, indicating stronger liquidity. For example, a current ratio of 2.0 means the company has $2 of current assets for every $1 of current liabilities. Current assets include items like cash, accounts receivable, and inventory, while current liabilities include accounts payable, short-term debt, and other obligations due within a year. If the ratio is too low, there’s a greater risk of not meeting obligations; if it’s very high, it might suggest assets are not efficiently used, but the liquidity signal remains that the company can cover short-term liabilities more easily.