The current ratio is a vital liquidity ratio that measures a company’s liquidity position. It is helpful to the internal finance manager and equally useful to creditors, lenders, banks, investors, etc. It is simple but provides incredibly useful information to financial analysts. The low current ratio is a direct sign of a high risk of bankruptcy, and too high would impact the profits adversely.
It is one of the liquidity ratios calculated to manage or control a company’s liquidity position. At the outset, the point of thinking is why we need to manage liquidity positions. Essentially, a company’s liquidity refers to its ability to honor its creditors or other vendors. Now, liquidity position assumes a position similar to a scale with a cost of funds on one end and risk of bankruptcy on the other. If we keep lower than required funds, the probability of dishonoring our dues is too high. On the contrary, if we keep abundant funds, the cost of funds (in the form of interest cost) would reduce the profits. So, a balanced situation is desirable as far as liquidity is concerned.
Keep reading How to Reduce Current Ratio & Why?
Calculation using Formula
Calculation of the current ratio is very simple. It is just a proportion of the current asset to current liabilities. Sometimes, these figures are readily available. But at times, we need to determine them using the company’s financial statements. Now, we discuss its formula:
Current Ratio = Current Assets / Current Liabilities
For calculation, you can use our Current Ratio Calculator.
It includes all those items which are either cash or can be converted into cash in a short while. Generally, this period is of one year. Although the following list cannot be comprehensive we have tried to cover most of them. Current Assets include the following items:
- Inventory / Stock
- Debtors and Bills Receivables
- Cash and Bank Balances
- Short Term Loans
- Marketable Investment / Short-Term Securities
The same is the case with current liabilities. Current liabilities are those liabilities that are payable in a year’s time. Current Liabilities include the following items:
- Sundry Creditors
- Outstanding Expenses
- Short Term Loans and Advances
- Bank Overdraft / Cash Credit
- Provision for Taxation
- Proposed Dividend
- Unclaimed Dividend
Keep reading LIQUIDITY RATIOS for learning about its other types.
Interpretation of Current Ratio
An increase in the numerator (current assets) increases the ratio in the current ratio and vice versa. At the same time, an increase in the denominator (current liabilities) decreases the same and vice versa. A current ratio of 2:1 is considered a lenient liquidity position, and 1:1 would be too tight. Whereas a ratio of 1.33:1 forms the base requirements of banks before sanctioning any working capital finance.
The company’s internal managers utilize the current ratio to analyze its financial position and take corrective action if need be. Investors or borrowers like banks or financial institutions use it to decide upon the company’s health and make decisions such as the sanction of loans, their respective amounts, etc. Creditors look at the current ratio of a company to evaluate whether it will be able to pay the dues on time or not.
Read more on How to Analyze & Improve Current Ratio?
Effective management of liquidity leads to improvement in profitability and thereby the investors’ wealth. Good bargain with creditors regarding credit period and control on the credit period of debtors can improve the company’s overall liquidity position and lower the cost of funds to finance working capital.
Quiz on Current Ratio
This quiz will help you to take a quick test of what you have read here.