The current ratio is a vital liquidity ratio that 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 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 the liquidity position of a company. At the outset, the point of thinking is why do we need to manage liquidity positions. 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.
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:
Current Ratio = Current Assets / Current Liabilities
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
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:
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.
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 the Current Ratio refer this article.