What is Current Ratio? – Definition
Current ratio or working capital ratio is a ratio of current assets to current liabilities of a business. In other words, it is defined as the total current assets divided by the total current liabilities. The Current Ratio is one of the oldest ratios used in liquidity analysis. It measures the number of times that the current liabilities could be paid with the available current assets.
Current ratio relates current assets to current liabilities and is designed to assist the decision-maker in determining a firm’s ability to pay its current liabilities from current assets. The current assets are cash or assets expected to turn into cash within the current year while the current liabilities are those that must be paid within the current year.
Current ratio Formula:
The current ratio is calculated as:
The numerator generally includes assets such as cash, short-term marketable securities, sundry debtors (accounts receivables), stocks (inventories) and prepaid expenses. The denominator, on the other hand, includes sundry creditors (Accounts Payabels), dividends, taxes due and short-term bank loans. A 2:1 current ratio is generally considered satisfactory by creditors. However, they should not rely too heavily on the current ratio, for it is quite possible to manipulate the current assets at the end of the accounting period to produce a ratio that may appear to satisfy the creditors, while in reality weakening the immediate liquid position of the company. For instance, the liquid position of companies X and Y is a follow
Company X has a better current ratio as compared to Company Y. However, an examination of the composition of current assets will reveal that cash and debtors of company X account for merely one-third of the total current assets, whereas in the case of Y three-fourth of the current assets are made up of these two liquid resources. Hence, Company Y’s ability to meet its current obligations can in no way be considered worse than X’s. It’s important to note here that Company X can further improve its current ratio by a slight manipulation i.e. if it uses the $80,000 cash in hand to pay off current liabilities the current ratio can to that extent be improved further. The new ratio would be:
The current ratio is a rough indicator of the degree of safety with which short-term credit may be extended to the concern. Generally, it is assumed that the higher the current ratio, the better is the position of the creditors because of the greater probability that debts will be paid when due. A high current ratio is not beneficial to the interest of the shareholders for it could mean that the company maintains excessive cash balance or has an over-investment in receivables and inventories.
Even from the point of view of creditors, a high current ratio is not necessarily a safeguard against non-payment of debts because a high current ratio represents two things; either an excess of cash or its equivalent relative to the current needs or a preponderance of current assets having low liquidity. Therefore, an analyst must, in addition to taking note of any window dressing a company may have done, consider the following before drawing any inference:
- Distribution if current assets
- Types of business — whether manufacturing or retailing
- Terms granted by creditors and by the company to its customers
How to express the current ratio?
This ratio may be expressed in any of the following three ways:
(a). It may be expressed as a proportion. i.e. current liabilities: current assets. In this case, current liabilities are expressed as 1 and current assets as whatever proportionate figure they come to.
For example, if current liabilities are $40,000 and current assets are $60,000, the current ratio would be: $40,000 : $60,000, or 1 : 1.5.
(b). It may be expressed as a number which is arrived at by dividing current assets by current liabilities. Thus, if a company’s total current assets are $90,000 and its current liabilities are $72,000, its current ratio would be $90,000/$72,000 = 1.25. If the current ratio of business is 1 or more, it means it has more current assets than current liabilities, i.e. it has a positive working capital. However, if the current ratio of a company is below 1, it shows that it has more current liabilities than current assets or negative working capital. Such a company is said to be an over-trading company. It is likely to face a lot of difficulty in meeting its day-to-day obligations.
(c). It may be expressed as a percentage, by showing current assets of a company as a percentage of its current liabilities.
For example, if a company’s current assets are $80,000 and its current liabilities are $64,000, its current ratio may be said to be 125%. If a company has a current ratio of 100% or above, it means that the company has a positive working capital. A current ratio of less than 100% indicates a negative working capital.
The most common way of calculating the current ratio is (b) above. i.e. as a number.
Current ratio calculator
The current ratio for John Ltd. in the given example can be calculated as shown below:
Current Ratio = 4,90,000 / 1,85,000 = 2.65:1
The current ratio for John Ltd. for the year 2019 is 2.65: 1. In other words, for every dollar of current liabilities, there is $2.65 in current assets. So a ratio of 2.65 means that John Ltd. has more than enough cash to meet its immediate obligations.
At one time, there was an old rule of thumb that the current ratio should be at least 2:1 to provide the proper margin of safety; however, some industries may require more or less. Thus, in actual practice, the current ratio tends to vary by the type and nature of the business. Everything is relative in the financial world and there are no absolute norms.