The current ratio denotes a company's competency to pay back its short-term debts and obligations. Such as bills payable, salaries and wages, etc.
The current ratio is a liquidity ratio which is the most well-known ratio to the shareholders. The current ratio can be found after dividing current assets by current liabilities.
The current ratio is to be considered a conservative ratio that shows the proportion between current assets and their current liabilities.
What is the current ratio?
The current ratio is a liquidity ratio that reflects the current assets or short term assets that are sufficient to repay the current liabilities within one year.
It reveals to the investors and analysts how competently a company utmost the current assets to fulfil its short term debts and other payables.
The current ratio assists to conduct the liquidity condition in the company. The current ratio is also known as the "working capital" ratio that establishes a relation between the current assets and current liabilities of the company.
It also shows the short-term financial position of the company. The higher the outcome, the excellent the financial achievement of the company.
How to calculate the current ratio?
The current ratio is an accounting term that is calculated by dividing current assets by current liabilities.
To calculate the Current ratio, analysts or investors judge the current assets of a company to its current liabilities.
Where current assets are those assets that are expected to be converted into cash within 12 months or one year.
For example, cash and cash equivalents, bills receivable, marketable securities, inventory, prepaid expenses, etc.
Current liabilities are those liabilities and obligations that have to be paid off within 12 months or one year.
For example, bills payable, short-term loans, bank overdraft, outstanding expenses, etc.
The formula for the current ratio
The Current ratio formula is mentioned below -
Current Ratio = (Current Assets/ Current Liabilities)
The result indicates the number of times that a company pays its current liabilities with its current assets.
Calculate current ratio with Example
Assume, it is ABC company. Here is some information about ABC company.
The balance sheet for company ABC
Year ended on 31 March 2019
Particular | Amount (Rs) |
---|---|
Non-current assets | |
Fixed assets | 425,000 |
Long term investments | 390,000 |
Total non-current assets | 815,000 |
Current assets | |
Cash in hand | 20,000 |
Bills receivable | 50,000 |
Inventory | 250,000 |
Prepaid expenses | 100,000 |
Short term loans | 200,000 |
Total current assets | 620,000 |
Total assets | 14,35,000 |
Equity | |
Share capital | 600,000 |
Reserve | 330,000 |
Total equity | 930,000 |
Non-current liabilities | |
Debentures | 200,000 |
Long-term loans | 150,000 |
Total non-current liabilities | 350,000 |
Current liabilities | |
Bills payable | 50,000 |
Overdraft | 100,000 |
Short-term loans | 5,000 |
Total current liabilities | 155,000 |
Total equity and liabilities | 14,35,000 |
Calculate the current ratio of the ABC company from the above data -
The current assets = Rs 620000
The current liabilities = Rs 155000
As per the formula,
Current Ratio
= Current Assets/Current Liabilities
= 620000/155000
= 4 times
The result indicates the company has 4 times more current assets than current liabilities. It implies that company ABC may not use its current assets appropriately.
Current ratio interpretation
The current ratio is the liquidity ratio that indicates the financial position of the company. The ratio enables an investor or analyst to analyze the company's short-term financial position in the market.
A good current ratio changes from one industry to another industry and its rivals. A higher current ratio is good for a business.
Usually, the current ratio of more than 1 denotes that a good Liquidity of a company and the company can comfortably pay off its short-term obligations.
The current ratio of less than 1 depicts that the company does not have enough resources to pay its dues promptly. It tells the bad Liquidity position of a company.
Even, the current ratio of less than 1 reflects the company is not earning enough cash from core business operations and ineffective collections of bills receivable.
If a company sold off its non-current assets for reimbursing current liabilities that indicates the company is not making enough income from core operations.
Even, a very high current ratio is not useful for a company and also indicates that the company is not able to exploit its current assets.
But need to know, only calculating the current ratio can not deliver the real snapshot regarding the term liquidity of a company and for this reason, investors need to do other ratio computations such as quick ratio, absolute quick ratio, etc.
What is a good current ratio?
Ideally, a good current ratio should be around 2, which tell us the current assets should be twice the current liabilities.
Whereas a good current ratio for banks is 1.33 to 3, it means the company is in a good condition.
If the current ratio fell over to near 1, it would be pointing that the company may have trouble with short term liabilities, and the company may not be able to pay off current liabilities with its current assets in near future. So, the thought process is entirely dependent on the different sectors.
The current ratio is more noteworthy when comparing companies within a similar industry and it is more crucial to find out a trend of the past few year’s current ratios of a company. Always a high current ratio is better than a lower ratio.
What are the limitations of the current ratio?
Some of the limitations of the current ratio are discussed below -
1. While computing the Current ratio, would need relatively liquid assets, for which the current ratio does not gauge the accurate liquidity level of a company.
2. If the company is operating under the seasonal business, the current ratio may not be able to give a true picture of the business.
3. The current ratio is wholly based on quantitative aspects and for which it is not possible to judge the qualitative aspects of the company.
4. The current ratio can be effortlessly manipulated which is why it does not furnish accurate truth to the shareholders.
Current Ratio vs. Quick Ratio: What are the differences between the current ratio and the quick ratio?
The quick ratio and current ratio both are considered as liquidity ratio that reflects the capability to repay its short term liabilities. The quick ratio is more conservative as compared to the current ratio.
The current assets comprise all the short term assets but the case of quick ratio contains quick assets which convert into cash within 90 days or 3 months such as, cash & cash equivalents, bank deposits, etc.
Difference between current ratio and a quick ratio
1. The current ratio is the efficiency to pay the company's short-term obligations whereas the quick ratio is the ability to pay the company's current liabilities.
2. The ideal current ratio is 2:1 on the contrary the ideal quick ratio is 1:1.
3. The current ratio is calculated by dividing current assets by current liabilities likewise the quick ratio is calculated by dividing quick assets by current liabilities.
How to improve the current ratio of a company?
Few basic steps help to improve the current ratio. The steps are given by -
1. Pay off current liabilities:
Quickly payment to the creditors and interest could save finance costs. Consequently, current liabilities would be lessened. Hence, the current ratio will enhance.
2. Sell off unproductive assets:
Sell unused or obsolete fixed assets and transmute these assets into cash. Therefore, the cash level would increase and current assets will grow.
3. long term borrowings vs short term borrowings:
Current assets will improve on the balance sheet by reducing short-term borrowings and improve the current ratio percentage.
4. Increase current assets by using shareholder's capital:
At the time of purchase of current assets by using equity share capital, the volume of current assets will expand but current liabilities will remain the same.
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