What is the Current Ratio?
The current ratio is also commonly referred to as the working capital ratio. It measures the ability of a business to meet its short-term obligations that are due within a year. The ratio takes into consideration the total current assets versus the current liabilities. It gives an indication of the financial health of the company and how it can maximize the liquidity of the current assets for clearing payables and debts.
Here is the current ratio formula generally used in the calculations.
Current Ratio= Current Assets / Current Liabilities
Current assets are the assets of a company that can be converted into cash within a year. It also refers to cash and cash equivalents. Examples of current assets include prepaid expenses, inventors, account receivables, and others. Current liabilities are short-term financial obligations that are expected to be due within one year such as lease payments, wages, accounts payables, and short-term bank loans. Both assets and liabilities of a company can be found from their balance sheet.
- The current ratio is one of the several liquidity ratios used in studying the ability of a company to meet its short-term obligations.
- The current ratio is also referred to as the working capital ratio and describes the relationship between the company’s assets that can be converted in less than a year and the liabilities that can be paid in a year.
- The current ratio of a company can also be estimated by dividing the current assets by current liabilities.
What is a Good Current Ratio?
A current ratio between 1.5 and 2 is generally considered beneficial for a business. This implies that the company has more financial resources for covering its short-term debt and it is operating under stable financial solvency. A very high current ratio indicates that the business is not able to manage its capital in an efficient manner to produce profits.
A low current ratio of less than 1 indicates that the company’s current liabilities are more than its current assets and the business may not be able to cover its short-term debt with its existing financial resources. There is no ideal current ratio or any clear distinction between what makes a current ratio good or bad as each industrial segment has its own standard for defining current ratios.
It is essential to compare the current ratio of a company with its industry peers rather than comparing it in a generalized manner. If the current ratio of a company is considerably lesser than the industrial average, then you will have to investigate what is resulting in that outcome. The same is applicable to other companies as well that have substantially higher current ratios in comparison to their industry peers.
You can also do a comparison of whether a current ratio is good or bad by analyzing how it has changed in the past years. A steady rise in the current ratio indicates that the company is working on improving its liquidity whereas a decline in the current ratio over the years indicates that the financial stability of the company has been worsening gradually.
Adopting the above-mentioned approach would provide you a better idea about the short-term liquidity of the company.
Importance of Current Ratio:
The current ratio quickly estimates the financial health of a company and its overall wellbeing. It is also a reflection of how well the management is utilizing the working capital. Using this ratio alone will not help you assess the short-term liquidity of a company.
The current ratio accounts for all the current assets of a company and it does not take into account certain assets that cannot be converted into cash easily. For instance, inventory is quite difficult to convert into cash in comparison to accounts receivable and hence is not taken into account for current ratio analysis.
This methodology may make the liquidity position of the company appear more lucrative than it actually is. Also, as the current ratio is indicating just the financial position of the company at the current time, it would not provide a complete picture of the company’s solvency or liquidity.
Current Ratio interpretation:
A business retains a certain level of inventory so that it does not have to face out of stock situations in life. Likewise, it also holds a minimum amount of bank balances and cash to meet its day-to-day expenses. Also, it extends credit to customers thereby creating bills receivable or sundry debtors. All of these components contribute to current assets and they can be expected to be converted into cash or cash equivalents in a short period of time.
The current assets are not entirely funded or financed by the own resources of the company. These are partly funded by the suppliers by short-term borrowing; by extending credit etc. the current liabilities are also referred to as short-term in nature and are expected to be cleared by a business in a very short time frame.
The current ratio also does a comparison of current assets to current liabilities. As current liabilities need to be honored for maintaining the creditworthiness and reputation, an organization needs to hold sufficient current assets for meeting its current liabilities.
A current ratio of 2 is believed to be a minimum as per general financial management standards. However, in small and medium companies in India, a current ratio of 2 is seldom observed. A ratio of anywhere between 1-2 is considered good and in some cases, the current ratio of less than one is also considered good.
Indian banks considered 1.25 as the ideal current ratio. Some banks expect it to be a minimum of 1.17 depending upon the industry. When the ratio falls below one, a company has to induct long term funds for strengthening its current ratio.
Current Ratio Example:
This example will clearly indicate what a current ratio indicates.
If a company ABC Ltd. holds cash of ₹15 lakhs, inventory of ₹25 lakhs, marketable securities of ₹20 lakhs, short term debt of ₹15 lakhs, and accounts payables of ₹15 lakhs,
Then the current ratio for company ABC Ltd. would be,
Current assets=₹15 lakhs + ₹20 lakhs + ₹25 lakhs = ₹60 lakhs
Current liabilities= ₹15 lakhs + ₹15 lakhs = ₹30 lakhs
Current ratio= ₹60 lakhs / ₹30 lakhs = 2.0
As per the calculations, the company has a current ratio of 2.0. This indicates that it can easily settle its accounts payable twice. A ratio of 1 and above indicates the financial well-being of the company.
The current ratio is one of the most crucial ratios indicating the financial health of a company. Although it is not a conclusive one, it can be used with our liquidity ratios to gain a comprehensive view of the finances of a company.