Investors and analysts want to know if a company will be able to pay off any outstanding debts or short-term financial obligations to clients or lenders. The better a company is at paying its debts, the safer it is to invest in. The current ratio reveals this to investors. It is an accounting ratio and a liquidity ratio that assesses a company’s ability to pay off its debts within a year. It explains to investors how a firm utilizes the assets on its balance sheet to pay down its debt and other obligations. A company’s current assets are compared to its ongoing liabilities to determine its current ratio.
What is Current Ratio?
The current ratio of a firm measures the ability to pay its current or short term liabilities with its current or short term assets. It is also known as ‘working capital ratio. From the various assets available, only current assets are considered for the current ratio calculation. Current assets are the possessions of the company that can be easily converted to cash within a year. Short liabilities that are due for payment within a year fall under current liabilities.
Current Ratio Formula
The Current Ratio Formula is:
Current Ratio = Current Assets / Current Liabilities
How to Calculate Current Ratio?
The Illustration on Calculation of Current Ratio is:
|Cash and cash equivalents||Rs 3,20,000|
|Accounts receivables||Rs 2,20,000|
|Prepaid expenses||Rs 2,40,000|
|Marketable securities||Rs 4,10,000|
|Advance Received||Rs 2,40,000|
|Accounts payable||Rs 3,20,000|
|Accrued liabilities and other debts||Rs 2,80,000|
(Cash and cash equivalents + Accounts receivables + Prepaid expenses + Inventory + Marketable securities)
(Rs 3,20,000 + Rs 2,20,000 + Rs 2,40,000 + Rs 1,80,000 + Rs 4,10,000)
(Advance Received + Accounts payable + Accrued liabilities and other debts)
(Rs 2,40,000 + Rs 3,20,000 + Rs 2,80,000)
(Current Assets / Current Liabilities)
(Rs 13,70,000 / Rs 8,40,000)
Components of Current Ratio
The current ratio is a liquidity ratio that is computed by dividing current assets by current liabilities. Therefore, the two main components are current assets and current liabilities.
Current assets are the assets that can be easily converted to cash within a year. They can be utilized to fund day-to-day operations as well as pay for ongoing operational expenses. Hence, they are extremely valuable for any business. Investors and analysts specifically observe the movement in the current asset balance to understand the viability of a company. The following assets fall under the current assets category:
- Cash and cash equivalents
- Accounts receivables
- Prepaid expenses
- Marketable securities
Current liabilities are a firm’s short term financial obligations that are due within the next year. These are usually settled with current assets. Like current liabilities, current assets are consumed within a year. Investors and creditors particularly value current liabilities evaluation. The following debts fall under the current liabilities category:
- Short-term debt (due within 12 months)
- Accounts payable
- Accrued liabilities and other debts
Limitations of Using Current Ratio
- Inventory or Stock-in-Trade : Current assets ratio includes a significant amount of inventory assets, which can be difficult to liquidate. This can be especially problematic if management employs aggressive accounting practices to apply an exceptionally high amount of overhead charges to inventory, inflating the total levels of inventory. Moreover, converting inventory to cash might take longer than 12 months. To convert an inventory to cash, the company will have to go through the sales cycle starting from sales negotiation to actual payment by debtors.
- Payment of Credit : When a company is using its line of credit to pay invoices as they become due, the cash balance is close to zero. Even if the current ratio is low in this scenario, the presence of a line of credit helps the company to make timely payments. In this case, the company should inform its creditors about the extent of the remaining line of credit, which can be utilized to pay extra debts. However, whether the company will be able to pay off the line of credit in the long run remains a concern.
- Across Industries : Companies in different industries have different financial structures. So comparing current ratios across industries is extremely difficult. Instead, the current ratio should only be used for intra-industry comparisons.
Explore Golden Rules of Accounting
Analysis of Current Ratio
High vs Low Current Ratio
The higher the current ratio, the better a company appears to be at paying its annual debts. This is because a high ratio implies that a company has a higher proportion of short-term assets than short-term liabilities during the same time period. If the current ratio is less than one, the company’s current liabilities are more than its current assets.
The interpretation is not as straightforward as “higher is better.” If a company’s ratio is greater than 3, it means it has enough cash to meet its liabilities three times over. However, it also means it isn’t managing its assets as efficiently as it may be. It is not adequately ensuring its finance by maximizing the profitability of its working capital.
The frequency with which a current ratio varies will ultimately determine whether it may be classified as “good” or “negative.” A corporation may have an excellent current ratio now, but its working capital is becoming increasingly inefficient. Alternatively, a company’s current ratio could be below one but gradually increase over time to achieve acceptable levels. Ideally, one should look for companies that have a high current ratio with consistency.
explore our article on What is Liquidity Trap?
Low Sales and Seasonal Stocks
Due to low sales frequency or obsolete products, companies selling non-durable goods must write off inventories. This includes food, clothing, and shoes, among other things. A company offering highly non-durables has a volatile current ratio.
Seasonal stocks are in high demand for a limited time. For instance, the selling of air conditioners, rain boots, raincoats, and winter clothing. All of this has a direct impact on the cash flow and current ratio of a company. As a result, rather than looking at single statistics, analyse yearly patterns in current ratios.
Frequently Asked Questions
A good current ratio falls within the range of 1.5 to 2. However, this may differ based on the industry in which the company operates. The current ratio serves as an indicator of a company’s ability to pay off its immediate debts and liabilities, should the need arise.
A current ratio of 2 implies that the company has sufficient current assets to cover its short-term liabilities, with twice as many assets as liabilities. Conversely, a current ratio below one indicates inadequate liquid assets to meet its short-term obligations.
Long Term Portfolio
The right mutual funds for your long-term goals with inflation-beating growth plus risk management.