Current Ratio:
It is a measure of general liquidity and is
most widely used to make the analysis for short term financial position or
liquidity of a firm. It is calculated by dividing the total of the current
assets by total of the current liabilities.
Contents:
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Definition of current ratio
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Formula
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Components
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Example
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Significance
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Limitations of current ratio
Current ratio may be defined as the relationship between current assets and
current liabilities. This ratio is also known as "working capital ratio". It is a
measure of general liquidity and is most widely used to make the analysis for
short term financial position or liquidity of a firm. It is calculated by
dividing the total of the current assets by total of the current liabilities.
Following formula is used to calculate current
ratio:
Current Ratio = Current Assets /
Current Liabilities
Or
Current Assets : Current
Liabilities
The two basic components of this ratio are
current assets and current liabilities. Current assets include cash and those
assets which can be easily converted into cash within a short period of time,
generally, one year, such as marketable securities or readily realizable
investments, bills receivables, sundry debtors, (excluding bad debts or
provisions), inventories, work in progress, etc. Prepaid expenses should also be included in current
assets because they represent payments made in advance which will not have to be
paid in near future.
Current liabilities are those obligations which are payable within a short
period of tie generally one year and include outstanding expenses, bills
payable, sundry creditors, bank overdraft, accrued expenses, short term
advances, income tax payable, dividend payable, etc. However, some times a
controversy arises that whether overdraft should be regarded as current
liability or not. Often an arrangement with a bank may be regarded as permanent
and therefore, it may be treated as long term liability. At the same time the
fact remains that the overdraft facility may be cancelled at any time.
Accordingly, because of this reason and the need for conversion in interpreting
a situation, it seems advisable to include overdrafts in current liabilities.
Current assets are $1,200,000 and
total current liabilities are $600,000.
Calculate current ratio.
Calculation:
Current Ratio = 1,200,000 / 600,000
= 2
or
1200,000 : 600,000
2 : 1
This ratio is a general and quick measure of liquidity of a firm. It
represents the margin of safety or cushion available to the creditors. It is an
index of the firms financial stability. It is also an index of technical
solvency and an index of the strength of working capital.
A relatively high current ratio is an indication that the firm is liquid and
has the ability to pay its current obligations in time and when they become due.
On the other hand, a relatively low current ratio represents that the liquidity
position of the firm is not good and the firm shall not be able to pay its
current liabilities in time without facing difficulties. An increase in the
current ratio represents improvement in the liquidity position of the firm while
a decrease in the current ratio represents that there has been a deterioration
in the liquidity position of the firm. A ratio equal to or near 2 : 1 is
considered as a standard or normal or satisfactory. The idea of having double
the current assets as compared to current liabilities is to provide for the
delays and losses in the realization of current assets. However, the rule of 2
:1 should not be blindly used while making interpretation of the ratio. Firms
having less than 2 : 1 ratio may be having a better liquidity than even firms
having more than 2 : 1 ratio. This is because of the reason that current ratio
measures the quantity of the current assets and not the quality of the current
assets. If a firm's current assets include debtors which are not recoverable or
stocks which are slow-moving or obsolete, the current ratio may be high but it
does not represent a good liquidity position.
This ratio is measure of liquidity and should be used very carefully because
it suffers from many limitations. It is, therefore, suggested that it should not
be used as the sole index of short term solvency.
- It is crude ratio because it measure only the quantity and not the quality
of the current assets.
- Even if the ratio is favorable, the firm may be in financial trouble,
because of more stock and work in process which is not easily convertible into
cash, and, therefore firm may have less cash to pay off current liabilities.
- Valuation of current assets and window dressing is another problem.
This ratio can be very easily manipulated by overvaluing the current assets.
An equal increase in both current assets and current liabilities would
decrease the ratio and similarly equal decrease in
current assets and current liabilities would increase current ratio.
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