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The current ratio is a vital liquidity ratio. It 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 current ratio impacts the profits adversely.
It is one of the liquidity ratios calculated to manage or control 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, 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.
How to calculate current ratio using Formula?
Calculation of current ratio is very simple. It is just a ratio of the current asset to current liabilities. Sometimes, these figures are readily available but at times, they are to be determined using the financial statements of the company. Ratio is stated as follows:
Current Ratio Formula
Current Ratio = Current Assets / Current Liabilities
Current assets include all those items which are either cash or can be converted into cash in a short while. This period is generally considered a year. Although the following list cannot be comprehensive but we have tried to cover most of them. Current Assets include 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:
- 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 ratio and vice versa. A current ratio of 2:1 is considered a lenient liquidity position and 1:1 would be too tight. A current ratio of 1.33:1 forms the base requirements of banks before sanctioning any working capital finance.
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 linkLast updated on : August 31st, 2017