Current Ratio

Definition

The current ratio (also referred to as the working capital ratio) is a formula that helps companies to measure their ability to pay off their short-term liability dues within a year. It aims to show how they can maximise their current assets to settle their short-term debts to creditors. It is calculated by dividing the total value of the current assets of a business by the value of its current liabilities. The formula for calculating the current ratio is given below:

Current Ratio = Current Assets/Current Liabilities

Current assets are those assets on an organisation’s balance sheet that can be converted into cash within a year. They include cash and cash equivalents, inventory, marketable securities, prepaid expenses and accounts receivable. On the other hand, Current liabilities are the short-term obligations that a firm has to pay off to its creditors within a year. Common current liabilities found on the balance sheet include short-term debt, dividends payable, accounts payable, outstanding income taxes, accrued expenses and notes payable.

Advantages of Current Ratio

There are a number of advantages of measuring the current ratio for a company which we will discuss below:

• The primary advantage for a company of using the current ratio is that it can help them measure their financial health. If the current ratio is less than one, it means that the firm needs to shore up its current assets to cover the immediate debt obligations or else it may face liquidity problems.
• The current ratio also helps the firm to understand the efficiency of its operating cycle. It is important because in case the current ratio is lower than 1, the management will need to address this issue immediately before it causes any problems.
• Calculating the Current Ratio also informs the management of a firm if they have enough current assets to pay off their current liabilities within a year. If a company is able to record a current ratio of greater than one, it means that the firm has more than enough current assets to cover the near term liabilities.

Also read: Difference between Current ratio and Quick ratio

Limitations of Current Ratio

The main limitations of using the current ratio formula are as follows:

• The Current Ratio is not a foolproof indicator of the liquidity position of a company. It would not be advisable for the management to rely on this ratio as it does not give information on things like working capital which would help them to assess the firm’s financial position.
• The calculation of the Current Ratio includes inventory (as it is a part of the current assets). The problem with including inventory is that it can take more than a year to get converted to cash in many cases. So if the management relies solely on the Current Ratio, they may end up overestimating the firm’s ability to pay off their short-term debt obligations.
• Any company whose sales figures fluctuate on a seasonal basis may end up having an inconsistent current ratio. If the sales are high, the ratio will be greater, and if the sales are low, it will adversely impact the ratio as well. In that case, the management would be mistaken to rely solely on the current ratio to assess the financial health of the company.

Conclusion

The Current Ratio is a very important measure to assess the ability of a firm to pay off its short term liabilities to creditors. It will help the firms assess their liquidity, but they should refrain from solely relying on just one figure to assess the financial position of an organisation.

Also See:

• Adjustment for Accumulated Profits and Losses
• Balance Sheet Vs Consolidated Balance Sheet
• Balance of Payments Surplus and Deficit
• Difference Between Capital Expenditure and Revenue Expenditure