Reading the current ratio in an audit
The current ratio measures whether short-term assets cover obligations due within a year. In an audit it is a planning analytic and an input to going concern: AU-C 570 and ASC 205-40 treat adverse financial conditions, such as negative working capital, as events to weigh in evaluating whether substantial doubt exists about an entity's ability to continue as a going concern.
Classification matters. Under ASC 470-10-45, long-term debt that is callable at the balance sheet date because of a covenant violation is generally classified as current unless the lender has waived the right for more than a year. That single reclassification can turn a comfortable ratio into a ratio below 1.0, so recompute after proposed audit adjustments.
Common questions
What is the current ratio formula?
Current ratio = current assets ÷ current liabilities. A company with $2.6 million of current assets and $1.6 million of current liabilities has a current ratio of 1.63.
What is a good current ratio?
Between about 1.2 and 2.0 is common for operating companies, but it varies by industry. Below 1.0 means current liabilities exceed current assets. A very high ratio can mean idle cash, slow-moving inventory or receivables that are not being collected.
What is the difference between the current ratio and the quick ratio?
The quick (acid-test) ratio excludes inventory and prepaid expenses, counting only cash, short-term investments and receivables. It shows whether the company can meet current obligations without selling inventory.
How do auditors use the current ratio?
As an analytical procedure in planning and in the going concern assessment under AU-C 570, and to check loan covenants that set a minimum current ratio or working capital. Reclassifying debt to current after a covenant breach can change the ratio sharply.
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