CURRENT RATIO FORMULA
Current ratio explains the relationship between current assets and current liabilities. This ratio is also known as working capital ratio. This ratio is a measure of general liquidity and is most likely to make the analysis of the short term financial position or liquidity position of the firm. It is calculated by dividing the current assets with the current liabilities. The Current Ratio formula is:
CURRENT RATIO= Current Assets/ Current Liabilities
EXAMPLE: Suppose the current assets of a concern as Rs. 2,50,000 and current liabilities of the concern are Rs. 1,00,000. The current ratio will be calculated as follows:
Current ratio= Current Assets/ Current Liabilities
Current ratio= 2,50,000/1,00,000
Current Ratio= 2.5:1.
Current assets are the assets which are likely to be converted into cash or cash equivalents within 12 months from the date of balance sheet or within the period of operating cycle. Current assets include the following assets:
- Current investments
- Stock or inventories
- Trade receivables i.e. debtors and bills receivables.
- Short term loans and advances
- Cash in hand
- Cash at bank
- Prepaid expenses
- Accrued incomes, etc.
Current liabilities are the liabilities payable within 12 months from the date of balance sheet or within the period of operating cycle. Current liabilities includes the following liabilities:
- Short term borrowings
- Trade payables i.e. creditors and bills payable
- Short term provisions
- Outstanding expenses
- Incomes received in advance, etc.
INTERPRETATION OF THE RATIO
A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current obligations in time as and when they become due. The high current ratio may not be favorable due to the following reasons:
- There may be slow moving stocks. The stocks will be pile up due to poor sale.
- The figures of debtors may go up because debt collection is not satisfactory.
- The cash or bank balances may be lying idle because of insufficient investments opportunities.
A relatively low current ratio represents that the liquidity position of the firm is not good and the firm shall not be very able to pay its current liabilities in time without facing difficulties. A low current ratio may be not favorable due to the following reasons:
- There may not be sufficient funds to pay off liabilities.
- There business may be trading beyond its capacity. The resources may not warrant the activities.
IDEAL CURRENT RATIO
The ideal current ratio is considered in the ratio of 2:1 i.e. current assets double the current liabilities is considered to be satisfactory. The idea of having double the current assets as compared to current liabilities is to provide for delays and losses in the realization of current assets.
FACTORS TO BE CONSIDERED WHILE USING CURRENT RATIO
A number of factors should be taken into consideration before reaching the conclusion about short-term financial position. Some of these factors are as follows:
TYPE OF BUSINESS: Current ratio is influenced by the type of business. A business with heavy investments in fixed assets may be successful even if the ratio is low. On the other hand, a trading concern will require a high current ratio because it has to pay its suppliers quickly.
TYPES OF PRODUCTS: The type of products in which a business deals also influences current ratio. A business dealing in goods whose demand changes fast will require a higher current ratio. On the other hand, if products have more intrinsic value such as gold, silver, metals etc. a lower current ratio may also do.
REPUTATION OF THE CONCERN: A business unit with better goodwill and reputation may afford a small current ratio because the turnover is more and creditors also allow credit for longer periods. A new concern or a concern which has not established its reputation will need higher current assets to pay current liabilities in time.
SEASONAL INFLUENCE: Current assets and current liabilities change with the seasons. In a peak season, current assets will be more and current ratio will be high. On the other hand this ratio will go down when the season is off.
TYPE OF ASSETS AVAILABLE: This type of current assets in the business also influences interpretation of current ratio. If the current assets include large amounts of slow moving stocks then even a high ratio may not be satisfactory.
All the above mentioned factors should be taken into mind while interpreting current ratio.
OBJECTIVE AND SIGNIFICANCE OF CURRENT RATIO
Current ratio is a general and quick measure of liquidity of a firm. It represents the ‘margin of safety’ or ‘cushion’ available to the creditors and other current liabilities. It is most widely used for making short-term analysis of the financial position or short-term solvency of the firm.
LIMITATIONS OF CURRENT RATIO
The following are the limitations of the current ratio are as follows:
CRUDE RATIO: It is a crude ratio because it measures only the quantity and not the quality of current assets.
WINDOW DRESSING: The valuation of current assets and window dressing is another problem if current ratio. Current assets and liabilities are manipulated in such a way that current ratio loses its significance. Window dressing may be indulged in the following ways:
- Over valuation of a closing stock.
- Obsolete or worthless stocks are shown in the closing inventory at their costs instead of writing them off.
- Recording in advance cash receipts applicable to the next year’s sales.
- Omission of a liability for merchandise included in inventory.
- Treating a short-term obligation as a long-term liability.
- Inadequate provision for bad and doubtful debts.
- Inclusion in debtors advance payment for purchase of fixed assets.
Window dressing is done to show current ratio at a particular figure. It does not present the real financial position of the concern. The inferences drawn on such a will be faulty and deceptive.