CURRENT RATIO — MEANING, SIGNIFICANCE, LIMITATIONS AND EXAMPLES

Post a Comment

The current ratio is the financial ratio that shows the ability to repay short term debt and obligations with its current assets

It is the financial ratio that shows the relationship between the current ratio and current liabilities.

The current ratio is one of the financial ratios used to assess the short term liquidity of a company.

Another name for the current ratio is the working capital ratio.

To compute the current ratio, we divide current assets by current liabilities.

$$\text{current ratio}=\frac{\text {current assets}}{\text{current liabilities}}$$

Current assets are those assets that can be easily converted to cash within a short period.

They are assets that can be easily converted to cash if necessary or are certain to be converted to cash within one year.

Current assets include cash at hand, cash at the bank, marketable securities, advance tax payment, trade receivable, prepaid expenses, bill receivables and inventories.

Current liabilities, on the other hand, are those debt obligations that are expected to be settled within one year.

Included are trade payable, bills payable, bank overdraft, dividend payable, tax payable, short term advances, accrued expenses, bank overdraft and other short-term cash credits.

SIGNIFICANCE OF CURRENT RATIO

When the current ratio exceeds one, the company has more current assets than current liabilities.

Simply stated, the firm has more than enough to pay its short term obligation and debt. 

If the current ratio is equal to one, it means that the firm has the same amount of current assets as its current liabilities.

This means that the firm has enough to pay its current liabilities.

However, such a company is vulnerable if the value of its current assets declines.

A current ratio of less than one indicates that the company has fewer current assets than current liabilities.

As such, the firm has a liquidity problem as it does not have enough to pay for its short term obligations and debts. 

It is generally believed, however, that a current ratio of 2:1 is satisfactory as it indicates that the company has twice as many current assets as current liabilities.

Stated differently, the company can pay off its short term obligations twice with its current assets.

The implication is that: even if the company's current asset lose half their value, it will still be able to cover its short-term debts or obligations.

However, Some banks still accept a current ratio of 1.33:1 as the minimum for the provision of working capital finance.

REASONS FOR A HIGH CURRENT RATIO

Even though companies strive for a current ratio greater than one, a high current ratio may be the result of the following negative factors:

1. Idle funds are kept in the bank, resulting in excessive cash balances.

2. Slow-moving stocks due to poor sales 

3. Unsatisfactorily debts collection

REASONS FOR A LOW CURRENT RATIO

1. Insufficient funds to make timely payments to creditors

2. The firm is selling beyond its available resources. That is to say, its resources are insufficient in comparison to the volume of sales. 

To put it in another way, the business is operating beyond its capacity.

LIMITATIONS OF CURRENT RATIO

1. Crude measure of liquidity: It is a crude measurement of liquidity as it only measures the quantity of current, not the quality or content of current assets.

This means it can not be relied on as a standalone measure of liquidity.

2. May be inaccurate: The current ratio is calculated using figures from the balance sheet. 

As a result, if the balance sheet from which the current ratio is calculated is incorrect, the current ratio will be incorrect as well.

3. Not an absolute measure of liquidity: Even if the current ratio is high, the company may be experiencing financial difficulties due to heavy stocks that are unable to be converted into cash and debtors that are not being realized within the standard credit period.

4. Unstable current ratio about seasonal sales: The current ratio can change depending on the season.

In some periods, the current ratio may be higher, while in others, it may be lower, most especially when sales are seasonal.

5. May paint a rosier picture of liquidity: Current ratio includes inventory in its calculations and this means overestimation of liquidity.

This is because inventory is the least liquid asset, therefore adding it to the current ratio may give a falsely optimistic view of a company's liquidity. 

We conclude with this example.

Example

The following balances were extracted from the books of Kenny limited. 

XY
Creditors60004000
Capital40006000
Furniture10001000
Cash500100
stock15007000
Debtors70001900

Calculate the current ratio for years X and Y

Solution

As noted earlier, the current ratio is calculated as

$$\text{current ratio}=\frac{\text {current assets}}{\text{current liabilities}}$$

$\text{current ratio of X}=\frac{500+1500+700}{6000}=1.5$

$\text{current ratio of Y}=\frac{100+7000+1900}{6000}=1.5$

Help us grow our readership by sharing this post

Related Posts

Post a Comment

Subscribe Our Newsletter