Current ratio comes under as one of the types of liquidity ratio. It is considered one of the essential financial measures and also empowers businesses as well as stockholders to form a reasonable judgment with respect to investments.
This guide will assist you in broadening your perspective about the ease of this particular liquidity ratio for users.
What is the Current Ratio?
Current ratio is the financial parameter that supports the investors and stockholders to evaluate the company’s capability to repay its straightway liabilities along with its current assets. In simpler words, it delivers a reasonable understanding about the company’s current assets in contrast to its current liabilities.
Another name for the current ratio is the working capital ratio. It is one of several liquid ratios that can be applied to indicate the company’s capability to utilize cash and cash equivalents to come across urgent working capital requirements.
In the absence of the current ratio of the firm, it is possible to discover the same ratio with the help of current assets and current liabilities noted in the balance sheet of the company.
Components of the Current Ratio
The following chart shows the two main components of the current ratio, i.e., current assets and current liabilities.
How to Calculate Current Ratio?
The company’s current ratio is figured out through the division of its total number of current assets by its total number of liabilities.
The formula to figure out the current ratio is given below: –
Current Ratio = Current Assets/Current Liabilities
The results show whether the company is able to settle its urgent liabilities along with its total current assets.
Example for Current Ratio
The below table is the balance sheet of some company
Particulars | Amount |
Assets |
|
Total Current Assets | 17,31,90,100 |
Total Non-Current Assets | 18,19,23,500 |
Total assets | 355,113,600 |
Liabilities |
|
Total Current Liabilities | 5,07,03,350 |
Total Non-Current Liabilities | 1,50,05,530 |
Total Liabilities | 65,708,880 |
Total current assets = Rs.355,113,600
Total current liabilities = Rs.65,708,880
According to the current ratio formula,
= Total current assets/ Total current liabilities
= 355,113,600/1,50,05,530
= 5.40
The output shows that the firm was capable of coming across its urgent liabilities productively. This indicates that the financial state of the company is affirmative.
Evaluation of the Current Ratio
According to the analysis of the current ratio the notion of good current ratio completely relies on the standpoint of the firm and its business competitors in which they are reviewed.
For example, firms that are in the retail industry usually display a high current ratio compared to the companies related to the service sector that have a low current ratio.
Generally, when the current ratio is less than 1, the company can go bankrupt within the span of the year, except if it increases its current cash flow or restores its capital.
On the flip side, if the current ratio is equal to 1, it indicates that the company is safe and does not imply any substantial liquidity-related challenges. It can be said that a higher current ratio is better for the company.
Anyhow, it is required to be noted that although a high current ratio follows no urgent liquidity considerations, it is not always the case to show the promising picture of the company surrounded by investors.
For example, investors might assume that the firm shows the high current ratio as it accumulates cash rather than paying dividends to the shareholders or occasionally reinvests in the business.
Importance of Current Ratio
Following are some benefits of the current ratio, as it is one of the most considerable financial measures for computing any company’s liquidity: –
- This financial performance metric is used to know about the company’s real-time financial position.
- The higher the ratio, the higher the liquidity as well as more stability.
- It can be used to enhance the firm’s capability to handle the creditors.
- This ratio aids in comprehending the requirements of working capital more efficiently.
- The current ratio is also used to identify the operating cycle of the company and its capability of getting more sales.
- It allows one to handle the inventory storage with more proficiency and fine-tune the overhead expenses.
- It is useful for making well-informed decisions on investments.
On the other hand, numerous flaws also exist. Users need to accompany them in advance to take full advantage of this financial metric without experiencing its limitations.
Limitations of Current Ratio
Below are the limitations of the current ratio:
- Without the assistance, the current ratio is not able to demonstrate the liquidity of the specific company with accuracy.
- The ratio depends on the numerical aspect of current assets and ignores its qualitative side.
- It accounts for a firm’s inventory, which most of the time overstates its liquidity disproportionately.
- Frequently falls short to measure the financial state of the company with accuracy as it fails to consider the rate of sales or discontinued goods.
- Companies having periodic sales most of the time display a variation in their ratio over the course of the operating cycle.
- A variation in the approach for inventory valuation additionally impacts the ratio, which is unrelated to the financial health or ability of repayment of the company.
- Due to its relative ease of manipulation, this ratio does not give investors or shareholders a realistic view.
Questions to Understand your ability
Q1.) What does the current ratio measure?
a) A company’s ability to generate profits from its assets
b) A company’s ability to repay its short-term liabilities with its current assets
c) A company’s market value compared to its liabilities
d) A company’s stock price relative to its earnings
Q2.) What is the formula for calculating the current ratio?
a) Current Assets / Total Liabilities
b) Current Assets / Current Liabilities
c) Total Assets / Total Liabilities
d) Non-Current Assets / Current Liabilities
Q3.) Which of the following is not a limitation of the current ratio?
a) The ratio depends on the numerical aspect of current assets but ignores the qualitative side.
b) The current ratio accurately demonstrates the liquidity of a company.
c) Companies with periodic sales may show variations in their ratio over the operating cycle.
d) A variation in inventory valuation can impact the ratio, unrelated to the company’s financial health.
Q4.) What does a current ratio of 1 indicate about a company?
a) The company is in financial distress and could face bankruptcy.
b) The company is safe and does not imply any substantial liquidity-related challenges.
c) The company has too much cash and is not utilizing its assets efficiently.
d) The company is unable to meet its short-term obligations.
Q5.) Which of the following could lead to an inflated current ratio?
a) High levels of non-current liabilities
b) Accumulating cash rather than paying dividends or reinvesting in the business
c) A higher sales rate
d) A well-managed inventory system
Conclusion
In conclusion, the current ratio is a key financial metric that helps assess a company’s liquidity and its ability to meet short-term obligations. While a high current ratio generally signals financial stability, it should be analyzed in context, as excessive cash accumulation or inventory overvaluation may mislead investors. Despite its usefulness, the current ratio has limitations, such as its inability to capture qualitative factors or reflect the actual financial health during fluctuating business cycles.
FAQ's
The current ratio is a key financial number that shows if a company can pay off its short-term debts with its current assets. In simple terms, it’s a measure of liquidity — how easily the company can handle its immediate financial obligations.
Easy! Just divide the company’s total current assets by its total current liabilities:
Current Ratio = Current Assets / Current Liabilities
That’s it. The result tells you if the company’s sitting pretty or in trouble when it comes to paying its short-term debts.
A ratio of 1 or above is usually solid. A ratio over 1 means the company has more assets than liabilities, so it can cover what it owes. If it’s under 1, though, the company’s in trouble and could be in danger of defaulting.
A current ratio below 1 is bad news. It suggests the company doesn’t have enough assets to cover its immediate debts, meaning it’s struggling to stay afloat. Unless it fixes its cash flow, it could face bankruptcy.
The current ratio is a quick way to check how healthy a company’s finances are in the short term. It shows investors and stakeholders if the company can handle its day-to-day financial needs without getting into trouble.
It’s not perfect. First, it doesn’t consider the quality of assets — it’s just numbers. Second, it can be misleading if a company’s inventory is inflated. Plus, it can be manipulated, so it doesn’t always give the full story.
The ideal current ratio changes by industry. For example, retail companies usually have a higher ratio because they hold a lot of inventory. On the other hand, service companies often have lower ratios because they don’t need as much stock to run.
Yes! A super high ratio might mean the company’s hoarding cash rather than using it to grow the business or pay out dividends. It could also indicate inefficiency — they’re not making the most of their assets.
