What is Current Ratio?

The current ratio is a liquidity and efficiency ratio that measures a company’s ability to pay off its current liabilities (CL) with its current assets (CA).

This is a measuring instrument though an analyst knows whether or not an organization has sufficient resources to pay its debts up to the next 12 months.

This means that a company has a limited amount of time in order to raise the funds to pay off for these liabilities.

Current assets include cash, cash equivalents, and marketable securities that can easily be converted into cash in the short term for up to 12 months.

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This means the organizations with more amounts of current assets will more easily be able to pay off current liabilities when they become due without having to sell off long-term, revenue-generating assets.

Prospective creditors utilize this ratio in shaping whether or not to make short-term loans. It can also provide the efficiency of a firm’s operating cycle or its ability to turn its product into liquid money.

This is also called the working capital ratio.

Advantages of Current Ratio:

1. Measures the liquidity of the company.
2. Represents the working capital position of a company.
3. Represents the liquidity of a company.
4. Represents the margin of safety.
5. It tells us the short term solvency capacity of a company.
6. Gives an idea of a company’s operating cycle.
7. Shows the management’s efficiency in meeting the creditor’s demands.
8. It enables the company to plan inventory storage mechanisms and optimize the overhead costs.

Disadvantages of Current Ratio:

1. Its correctness can be dissuaded as concerned with different businesses depending on various factors.
2. Over-estimation of stock also contributes to its tipping truth.
3. It measures the company liquidity on the basis of quantity and not a quality that comes across as a crude method.
4. On the basis of this ratio analysts may not be sufficient to analyze the liquidity position of the firm.
5. This includes inventory in the calculation, which may lead to the overestimation of the liquidity position in many cases.
6. This Ratio may be impacted due to a change in inventory valuation methodology by the company.

Formula

The formula is nothing but Total Current Assets divided by Total Current Liability.

Analysis and Interpretation of Current Ratios

Here we are looking at three conditions of the cash ratio which are as follows:

1. Current Assets > Current Liabilities i.e. cash ratio > 1 – means a desirable situation to be in.
2. Current Assets = Current Liabilities i.e. cash ratio = 1 – Current Assets are just enough to pay off the short term obligations.
3. Current Assets < Current Liabilities i.e. cash ratio < 1 – means company is facing a liquidity crisis. That means a problem situation at hand as the company does not have enough to pay for its short term obligations.

It assists investors and creditors to understand the liquidity position of a company and how easily that firm will be able to pay off its current liabilities.

This ratio indicates a firm’s current liabilities in terms of current assets. So this ratio of 2 would mean that the company has 2 times more current assets than current liabilities.

Lists of Current Assets

1. Cash on Hand or cash equivalent
2. Investments
3. Accounts receivable or trade receivable or Debtors
4. Inventory of raw materials, stocks, WIP, finished goods
5. Notes receivable maturing within one year
6. Other receivables
7. Prepaid expenses
8. Advance payments
9. Office supplies
10. Marketable securities

Lists of Current Liabilities

1. Account Payables
2. Accrued Compensation
3. Other accrued expenses
4. Deferred Revenues
5. Accrued Income Taxes
6. Short Term notes
7. Current Portion of Long term debt

Practical Example

The following data has been extracted from the financial statements of two companies – company A and company B.

Both company A and company B have the same ratio (2:1). Do both the companies have equal ability to pay its short-term obligations?

The answer is Company B is to have difficulties in paying its short-term obligations because most of its current assets consist of inventory. Inventory is not quickly convertible into cash.

Company A is likely to pay its current obligations as they become due because a large portion of its current assets consists of cash and accounts receivables. Accounts receivables are highly liquid. Conversion into cash is very quick.

By this ratio analysis, it is obvious that the analyst should not only see the current ratio but also the composition of the current assets of a specific firm.