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Contents:
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.
Current ratios is calculated by using the
following formula:
Current ratio = Current assets /
current liabilities
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:
- In case of slow moving stocks, these will
pile up and will lead to higher ratio.
- In case of slow collection of trade debts
it will also lead to higher ratio.
- Cash and bank balance may be more then
necessary consequently significant portion may remain idle which is not at
all desirable:
- On the other hand if the current ratio is
low due to following reasons it is again undesirable:
- Lack of sufficient funds to meet current
obligations and
- 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.
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. |
