Current Ratio is calculated as total current assets divided by total current liabilities for the most recent financial period. Current assets include short term assets like cash, inventory and receivables whereas current liabilities includes obligations that are due within 1 year such as short term debt, accounts payable etc.
Suppose total current assets of a company is Rs.250 and current liabilities is Rs.300, current ratio can be calculated as 250 / 300 = 0.83. So the company has Rs.0.83 current assets to meet every Rs.1 current liability.
The ratio helps understand the company’s ability to pay off its short term liabilities using its current assets. It is important to understand that while current ratio of 1 is considered optimal, an extreme divergence on either sides from this point is not desirable. A very low ratio indicates that the company is having trouble collecting from its debtors or takes a long time to sell inventory whereas a very high ratio indicates that the company might be holding lot of cash without investing the same appropriately.