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Current Ratio:

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Definition and Explanation:

Current ratio is also known as working capital ratio or 2 : 1 ratio. It is the ratio of total current assets to total current liabilities.

Current assets are those which are usually converted into cash or consumed with in short period (say one year). Current liabilities are required to be paid in short period (say one year).

Examples of current assets and current liabilities are as follows:

Current Assets Current Liabilities
Cash
Bank
Stock:
     Raw materials
     Work-in-progress
     Finished goods
Short-term investments
Sundry debtors (less provision)
Bills receivable
Recoverable advances, Prepaid Expenses
Sundry creditors
Bills payable
Outstanding expenses
Bank overdraft
Taxes etc., payable
Dividend payable
Short-term advances
 

In case where bank overdraft is permanent feature and minimum investment in stock cannot be en-cashed the same should not be treated as current items. But normally these are include under the current items.

Formula of Current Ratio:

Current ratios is calculated by using the following formula:

Current ratio = Current assets / current liabilities

Interpretation  of Current Ratio:

Current ratio indicates the liquidity of current assets or the ability of the business to meet its maturing current liabilities. High current ratio finds favor with short-term creditors whereas low ratio causes concern to them. An increase in the current ratio reflects improvement in the liquidity position of the business while the decrease signals that there has been a deterioration in the liquidity position of the business. As a convention 2 :1 is regarded as satisfactory level i.e. current assets should be almost double than the current liabilities. The idea is to provide for loss in the value of current assets due to probable decrease in the market value and to offered for any possible delay in the realization of current assets. However there is no scientific reasoning behind 2 : 1 norm. Current ratio compares only the quantity of current assets rather than the quality of assets. A high current ratio though considered to be desirable may prove to be otherwise due to following reasons:

  1. In case of slow moving stocks, these will pile up and will lead to higher ratio.
  2. In case of slow collection of trade debts it will also lead to higher ratio.
  3. Cash and bank balance may be more then necessary consequently significant portion may remain idle which is not at all desirable:
  4. On the other hand if the current ratio is low due to following reasons it is again undesirable:
  5. Lack of sufficient funds to meet current obligations and
  6. Trading level beyond the capacity of the business.

Before arriving at any conclusion based on the interpretation of current ratio the  following factors should be considered:

Nature of Business:

Public utility undertakings like electricity boards, transport corporations, municipal committees have the legal force to collect their dues in time so even a low current ratio need not cause any worry but normal trading business must have satisfactory current ratio.

Nature of Product:

A business dealing in consumer goods will require better current ratio as compared to a business which is dealing in durable or capital goods.

Reputation of the Business also Influences the Requirement of Liquidity:

A business having better reputation can do with small cash and bank balance as compared to comparatively unknown business house. It is so because well-known business shall enjoy favorable terms of credit.

Seasonal Influence:

In a business where raw material is a seasonal commodity like wheat or sugarcane, it will require the purchase of annual consumption in the season itself, thus, requiring higher investment in stock as compared to the business where purchases can be spread over evenly throughout the year.

Example:

From the following balance sheet, calculate current ratio:

Liabilities

$

Assets

$
Equity share capital 1,50,000

Land & building

100,000
Reserve and surplus 50,000 Plant & machinery 80,000
Debentures 60,000 Goodwill  20,000
Trade creditors 6,000 Cash 5,000
Bills payable 5,000 Investments (Short-term 15,000
Bank overdraft 5,000

Bills receivable

5,000
Outstanding expenses 1,000 Sundry debtors 22,000  
Income tax payable 30,000 Less provision 2,000 20,000
Proposed dividends 10,000 Inventories 30,000
    Work in progress 15,000
 
 
  2,90,000   2,90,000

Solution:

Current assets are: cash, investments, bills receivable, sundry debtors (net), inventories and work-in-progress.

 $5,000 + 15,000 + 5,000 + 22,000 - 2,000 + 30,000 + 15,000 = $90,000.

Current liabilities are trade creditors, bills payable, bank overdraft, outstanding expenses, income tax payable and proposed dividend.

$6,000+ 5,000+ 5,000+1,000+3,000+10,000 = $30,000

Current ratio = Current assets/Current liabilities

90,000 / 30,000

3 : 1

This means that for every  $1 worth of current liability there are current assets worth $3. It also means that the firm will be able to pay off its current liabilities in full even if current assets realizable value is 1/3rd of its book value.

More study material from this to
 

More study material from this topic:

Meanings, Nature and Usefulness of Ratios Analysis
Interpretation of Ratios
Important Factors for Understanding Ratios Analysis
Significance and Usefulness Ratios Analysis
Classification of Ratios
Analysis of Short Term Financial Position or Test of Liquidity
Current Ratio
Quick/Acid Test/Liquid Ratio
Absolute Liquid Ratio
Inventory/Stock Turnover Ratio
Debtors / Receivable Turnover Ratio
Creditors / Payables Turnover Ratio
Working Capital Turnover Ratio
Profitability Ratios
Gross Profit Ratio (GP Ratio)
Operating Profit Ratio
Net profit ratio (NP ratio)
Earnings Per Share Ratio
Operating ratio
Expense ratio
Solvency ratios - Test of Long Term Solvency
Debt-equity Ratio
Debt Service Ratio or Interest Coverage Ratio
Fixed Assets Ratio
Debts to Total Funds or Solvency Ratio
Reserves to Capital Ratio
Capital Gearing Ratio
Proprietary Ratio
Accounting Ratios Formulas
Limitations of Ratios Analysis

 

 
 

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Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
----------------------------------------------------------------------------
  Balanced Scorecard
----------------------------------------------------------------------------
  Capital Investment Analysis/Capital Budgeting
 
 

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