Current Ratio is a liquidity ratio which measures the ability of a company to be able to pay its debt obligations that may be short term or within a period of twelve months. It allows investors to understand how current assets can be maximized in order to satisfy payables and the current debts. The ratio looks at the current assets of a company in respect to its current liabilities.
It is called Current Ratio as it takes the ‘current’ assets and liabilities into account and it is also known as the working capital ratio.
What are the different Components involved in Current Ratio?
The two main components are, Current Assets and Current Liabilities.
- Current Assets can be converted into cash and cash equivalents within twelve months.
Cash, Inventory, marketable securities, accounts receivable are some of the current assets on a balance sheet which are to be liquidated in less than a year.
- Current Liabilities involve the obligations of a company which are to be paid off in a year.
Some of the current liabilities are sundry creditors, taxes payable, dividends declared, wages, short term debts, accounts payable and with long term debts they are the current portion of it.
How to Interpret the Current Ratio
If the current ratio of a company is less than 1, then it means the company has more liabilities and assets and if the payment obligations are due at this point, they will not be able to pay them as the company is not in ideal financial health. A company with a current ratio of less than 1 doesn’t mean that it can’t be included, but it is something to watch for. It should be in a similar position as compared to its industry peers.
Banks usually prefer giving loans to companies with a current ratio of between 1 and 2. It is between 1 and 2 and not simply taken as over 1 because, if the current ratio is too high then it gives a different impression. It ends up indicating that the company may not be securing financing well which could be a sign of something problematic. It could also mean that it’s not using its assets efficiently which is another sign of subpar financial health, so between one and two is pretty ideal but it’s not definite if it falls outside of that range.
How do we Calculate the Current Ratio?
In order to calculate current ratio, the current assets of a company are compared with its current liabilities.
The formula for Current Ratio is,
Current Ratio = Current Assets/ Current Liabilities
An example would be,
Total Current Assets = Rs. 150000
Total Non Current Assets = Rs 300000
Total Assets = Rs. 450000
Total Current Liabilities = Rs. 100000
Total Non Current Liabilities = Rs. 200000
Total Liabilities = Rs. 300000
Total Current Assets = Rs. 450000
Total Current Liabilities = Rs. 300000
Using the formula,
450000/ 300000 = 1.5
This shows that the company is in a state of favourable financial health.
What are the Benefits of using Current Ratio?
- A company’s immediate financial position can be determined with this ratio.
- Current ratio can help with providing information on a company’s operating cycle.
- More liquidity and stability can be indicated with a higher current ratio.
- Inventory and storage can be planned ahead and overhead expenses can be handled and optimised.
- It helps make better, informed decisions on investments.
- The management’s efficiency in meeting the demands made by creditors can be shown or displayed by the current ratio.
- It allows us to realise whether the condition of the business is getting better.
- The ratio can be compared with the current ratio of other years.
What are the Limitations of Current Ratio?
- It cannot be used alone as a ratio.
- It may not be fully accurate while calculating it due to short term assets such as inventory.
- Overvaluation of the current assets can lead to the current ratio being manipulated.
- The quality of the assets is not taken into consideration as only the quantitative aspect is.
- Liabilities can be ignored or neglected at certain points to get a good representation of a current ratio.
- The financial health of the firm may not be gauged accurately as the frequency of sales is not accounted for.
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