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Current Ratio

Concepts Behind Current Ratio

The current ratio is the ratio, which is used to check the financial health of a company. It is used to determine the liquidity of a company i.e. whether a company is able to pay back its liabilities using currents assets. The current ratio is used by investors to analyze whether they should invest in a particular company or not. Hence, it is crucial for both internal finance corporate and external stakeholders. It is obtained by dividing current assets and current liabilities of a company. Current assets include receivables, cash, investments, securities, etc. whereas current liabilities include payables, debt etc.

Current Ratio  =          Current Assets
                                    Current Liabilities

The values of acceptable current ratio vary depending on the particular industry. Usually, if a company has a current ratio from 1.5 to 3, it is considered as good financial health. It means the company can complete its liabilities with the help of its assets. If this ratio is less than 1, it indicates company financial health condition is not good. The company is unable to complete its liabilities. It does not mean that the company will be bankrupt. If the company has some investment which can be profitable in near future, then its current ratio will increase at that point of time and it will overcome its bad financial condition. However, less than 1 current ratio is not a good sign for any company. If a company's current ratio is greater than 3 that is also a concern. The high current ratio shows that the company is managing and utilizing its assets properly. It also means excess cash, which can reduce the profit of the company with interest costs. In these scenarios, a company looks forward for decreasing current ratio.

Let us see an example below for company ABC and XYZ. The table shows current assets and liabilities for both companies in the year 2014, 2015 and 2016.

Company

Assets/Liabilities

2014

2015

2016

ABC

Current Assets

7,734

5,389

9,687

Current Liabilities

4,678

6,899

5,741

XYZ

Current Assets

7,743

6,965

7,490

Current Liabilities

4,799

3,295

8,245

All above-mentioned amounts are in USD in millions.

Ans:

For company ABC in the year 2014:

Current ratio      = 7,734/4, 678

= 1.653

Similarly, by dividing current assets by current liabilities for each year, we will get current ratio as mentioned in below table:

Company

2014

2015

2016

ABC

1.653

0.781

1.687

XYZ

1.613

2.11

0.908

From the above result, we can analyze that financial health was good for both companies in the year 2014, as the current ratio was greater than one. Liquidity decreased for company ABC in 2015, but it improved its liquidity in 2016a. For company XYZ, 2015 was a progressive year in terms of current ratio, but its financial health condition falls down in 2016.

  • Difficulties Encountered In Current Ratio

It appears calculation of current ratio is easy from it formula. We will divide two numbers i.e. current assets value and current liabilities value and we will get the answer. But we should have a proper understanding of the components which fall under above-mentioned categories.

Cash credits, cash balance, short term investments (stocks, loans which are received, mutual funds etc.), borrowings, receivables, bank balance, inventories (raw materials, finished goods, work in progress) will come under assets. However, we should exclude loose tools, spares while considering current assets.

Cash payable, expenses (salary for employees, rent, etc.), interests, payable taxes, sundry creditors, loans which should be payable, unearned income, doubtful debts will come under liabilities.

We should make sure that we are considering these components for short span of time usually within 12 months.

  • Help With Current Ratio

We help students to understand current ratio concepts with examples, discussions and quizzes. Let us see an example below:

Balanced sheet of a company PQR for the year ending Dec 31, 2012

Current Assets:

 

Bank balance

- $1000

Accounts Receivable

- $200

Inventory

- $300

Total

:  $1500

Current Liabilities:

 

Expenses

- $400

Current long term debt

- $200

Payable taxes

- $200

Total

:  $800

Long Term Debt

- $400

Total Liabilities (Short term & Long Term)

:  $1200


As we know, the current ratio is the ratio of current assets and current liabilities.

Hence in this case,

Current ratio = 1500/800 = 1.975

We will exclude long-term debt here, as it will not come under current liabilities. So it will be considered while calculating current ratio.

We also provide an option of report error, if a student has any doubt in the content we publish on our website or app. We take it as feedback and try to improve our self in order to provide better help to students.

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