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Current Ratio: – The Current Ratio is a Liquidity Ratio that means company’s ability to pay short term & long term obligations. Current Ratio denotes proportion of current assets of business in respect of current liabilities.
Current assets are those assets that can be converted in to cash in business operating cycle which is twelve months. Current Assets mainly includes: Cash, Receivables, inventories, marketable securities and prepayments etc.
Current liabilities are debts or obligations that will be settled in business operating cycle which is generally twelve months. Current liabilities include: Accounts payable, unearned revenues and wages payable etc.
Current Ratio is also known as “Working Capital Ratio” & “Liquidity Ratio”.
Formula: – for calculating current ratio
|Current Ratio||=||Current Assets|
|Ideal Current Ratio For a company is 2:1.|
Example: PQR Ltd has the following assets and liabilities as at 31st December 2016:
|Amt in crores||Amt in crores|
|Non Current Assets|
|Cash in hand||40|
|Cash in bank||55|
|Income tax payables||60|
|Working Capital Loan CC/OD etc||15|
|Installments of Term Loan due in next Financial Year||10||190|
|Non Current Liabilities|
|Deferred tax payable||30||80|
Current ratio will be calculated as follows:
Explanation: – It shows current assets are sufficient to meet its current liabilities. It is a criteria to check company’s ability to pay short term obligations. In other words we can measure Company has enough funds to meet company’s short term liabilities. If current ratio is 2, it means company has sufficient current assets to cover the amount twice of its current liabilities.
Importance: Current ratio is used to evaluate the short term solvency of a business entity. The current ratio is evaluates firm’s liquidity. Suitable current ratios vary from industry to industry & person to person. If we talk about a creditor, he would like a high current ratio as compare to a low current ratio, because a high current ratio indicates company’s capability to pay off the creditor .On the other hands, high current ratio is not always a good sign for investors. If the company’s current ratio is too high it may represents that the company is not able to utilize efficiently its current assets or its short-term financing funds. Generally, accepted current ratio is 2: 1 or greater is satisfactory. However Financial Institutions while appraising a project are satisfied if current ratio is 1.3:1 or above.
Limitation: It is useful to compare the companies that are within same industries. Because business operations of industries are differ from one another, comparing the current ratio of companies that belongs to different industries with one another will not lead to any productive result.