Current Ratio

The current ratio is a vital liquidity ratio which measures the liquidity position of a company. It is useful not only to the internal finance manager but equally useful to creditors, lenders, banks, investors etc. It is simple but incredibly useful information for financial analysts. The low current ratio is a direct sign of high risk of bankruptcy and too high would impact the profits adversely.


It is one of the liquidity ratios calculated to manage or control the liquidity position of a company. At the outset, the point of thinking is that why do we need to manage liquidity position. Essentially, the liquidity of a company refers to its ability to honor its creditors or other vendors. Now, liquidity position just assumes a position similar to a scale with a cost of funds on one end and risk of bankruptcy on the other end. 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 very much desirable as far as liquidity is concerned.

Current Ratio

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 financial statements of the company. Hereby, we discuss its formula:

Formula

Current Ratio = Current Assets / Current Liabilities

 Where Current Assets are

Current RatioCurrent assets include 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

Where Current Liabilities are

Same is the case with current liabilities. Current liabilities are those liabilities which are payable in a year’s time. Current Liabilities include following items:

  • Sundry Creditors
  • Outstanding Expenses
  • Short Term Loans and Advances
  • Bank Overdraft / Cash Credit
  • Provision for Taxation
  • Proposed Dividend
  • Unclaimed Dividend

Interpretation of Current Ratio

In the current ratio, an increase in the numerator (current assets) increases the ratio and vice versa. Whereas 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.

[adsense_bottom]Internal managers of the company utilize current ratio to analyze its financial position and take corrective action if need be. Investors or borrowers like banks or financial institutions utilize it to decide upon the health of the company and take decisions such as 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.

Effective management of liquidity leads to improvement in profitability and thereby the wealth of the investors. Good bargain with creditors with regards to credit period and control on the credit period of debtors can improve the overall liquidity position of a company and lower down the cost of funds to finance working capital.

For advantages and disadvantages of Current Ratio refer this link

Sanjay Bulaki Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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4 thoughts on “Current Ratio”

  1. People parrot this nonsense without thinking it through. The current ratio describes the nature of the financing characteristics of working capital – greater than 1 working capital has to be financed from long-term debt and equity, less than one it is being used to finance non-current assets.
    Firms with cash sales, fast inventory turnover and in a powerful position with their suppliers generally have current ratios less than one. Such firms do not generally have liquidity problems unless they stop trading or start to shrink.

    Reply
    • Example:
      Cash Sales of 1 kg – 100
      Inventory at cost of 1 kg – 90
      Creditors for 2 kg @90 – 180, Consequently C.R. is More than 1.
      Here, firm with cash sales does not give C.R. less than 1.
      Please extend your thought…… so that I can understand your point of view.
      Thanks

      Reply

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