Current ratio measures the liquidity level of an entity. It indicates the ability of the entity to pay its current debts (current liabilities) out of its current assets. This is also called ‘the working capital ratio’. Short term creditors are particularly interested in this ratio.
Formula
We calculate current ratio where divide current assets by current liabilities.
Every Company/entity desires to perform operations smoothly and uninterruptedly. For this purpose adequate level of working capital is required which is equal to current assets minus current liabilities.
Working Capital = Current assets – Current Liabilities
It would not be out of place to acknowledge that the working capital is the life blood of business. Survival of an entity becomes hardly impossible without adequate working capital in hand. But this is really important to note that the working capital must always be measured in relation to the current assets and current liabilities. A specific relationship between current assets and current liabilities defines the status of working capital which is certainly very important for an entity to know. In other words this would mean that the amount or level of working capital itself may hold little importance unless the same is measured in relation to current assets and current liabilities. In order to understand this viewpoint, consider the following example of two companies.
|
A Ltd
$ |
B Ltd
$ |
|
|
Current Assets |
30,000 |
50,000 |
|
Current Liabilities |
20,000 |
40,000 |
|
|
|
|
|
Working Capital |
10,000 |
10,000 |
|
Current Ratio |
1.50 |
1.25 |
You can see that the working capital of both companies is the same i.e. $ 10,000/- yet the short term suppliers and creditors would like to extend their dealings with Company A because this company is having a better current ratio as compared to Company B. Therefore, working capital must always be measured in conjunction with current ratio.
Example
The following are the extracts of financial statements of M/s UNISA Pharmaceuticals (Pvt) Limited for the year ended December 31, 2016.
Current Assets
Stocks in trade $ 20,000
Trade receivables $ 15,000
Cash & bank balances $ 30,000
Total current assets $ 65,000
Current Liabilities
Trade payables $ 10,000
Current portion of long term liabilities $ 17,500
Accrued & other liabilities $ 5,000
Total current liabilities $ 32,500
Computation
Using the above current ratio equation = Current assets / Current liabilities
65,000 / 32, 500
Current ratio calculated is = 2.00 OR 2 : 1
Analysis
We have seen that the current ratio computes the liquidity position of an entity. This ratio indicates the ability of entity to meet its current obligations (liabilities) when they become due. In order to meet out these obligations upon their due dates, the entity must have enough resources in shape of current assets because the current assets are easily convertible into cash. Consequently, more emphasis is placed on current ratio because an entity may slump down due to its inability to meet out its current obligations even if it is earning good profits.
Generally, the ratio of 2:1 is considered a good current ratio, which means that the entity is having dollars 02 of current assets against dollar 01 of current liabilities. This is considered satisfactory because in such situation the entity will be able to fulfill its commitments (current liabilities) even if the process of conversion of current assets into cash (realization) becomes slightly sluggish. On the other hand, an undue high current ratio will indicate the requirement of more effective working capital management.