Current ratio is one of the most important types of liquidity ratio. It not just serves as a vital financial metric but also enables both businesses and stockholders to make informed decisions regarding investments. To further understand how this particular liquidity ratio comes in handy for users, one must become familiar with more than the current ratio meaning.
What is Current Ratio?
Typically, it is a financial metric that enables investors and stockholders to assess a firm’s ability to pay off its immediate liabilities with its current assets. In other words, it offers a fair idea about a firm’s current assets against its current liabilities.
The said ratio is also known as the working capital ratio. It is considered to be one of the few liquid ratios that can be used to gauge a firm’s ability to use cash and cash equivalents to meet immediate working capital needs.
In case the current ratio is not available for a company; one can find out the same by taking into account the current assets and current liabilities recorded in its balance sheet.
Components of Current Ratio
There are two primary components of current ratio, namely – current assets and current liabilities. Currents assets are essentially investments that can be readily converted into cash and cash equivalents within a year. It includes –
- Cash equivalents
- Accounts receivable
- Marketable securities
- Short-term deposits
On the other hand, current liabilities make up the financial obligations of a company that are typically paid off within a year. It includes –
- Income taxes
- Accounts payable
- Dividends declared
- Outstanding wages
How to Calculate the Current Ratio?
Typically, a company’s current ratio is computed by dividing its total current assets by its total current liabilities.
Current ratio formula is given by –
Current Ratio = Current Assets/Current Liabilities
The outcome indicates the number of times this company in question could pay off its immediate liabilities with its total current assets.
Calculation of Current Ratio Example
This table below is an excerpt from Ambuja Cements Limited balance sheet as on 30th December 2019.
Compute the company’s current ratio from the available information –
Total current assets = Rs.40,18,23,400
Total current liabilities = Rs.10,36,75,900
As percurrent ratio formula,
= Total current assets/ Total current liabilities
This outcome reveals that the company was able to meet its immediate liabilities successfully. In turn, indicating favourable financial health.
Analysis of Current Ratio
As per current ratio analysis, the concept of ‘good’ current ratio depends entirely on the context of a firm and its competitors, in which they are analysed. For instance, companies belonging to the retail industry often reflect a high current ratio, whereas those in the service sector reflect a low ratio.
Typically, a current ratio that is less than 1 indicates that the firm may become insolvent within a year unless it increases its current cash flow or replenishes its capital. On the other hand, a ratio equal to 1 may be deemed safe as it does not signify any major liquidity-oriented concerns. Generally, a higher current ratio is considered to be better.
Regardless, it must be noted that even though a high current ratio accompanies no immediate liquidity concerns, it may not always paint a favourable picture of the company among investors. For instance, they may assume that a company has a high ratio as it hoards cash instead of paying dividends to its shareholders or seldom reinvests in the business.
Significance of Current Ratio
The several benefits that accompany this ratio make it one of the most efficient financial tools to measure a firm’s liquidity.
The most prominent benefits of using current ratio are as follow –
- This financial metric helps to determine a company’s immediate financial standing.
- A higher ratio often indicates greater liquidity and more stability.
- It also helps to assess a firm’s ability to manage creditors.
- The financial tool helps to understand a firm’s working capital requirement more effectively.
- This ratio is also useful in determining a company’s operating cycle and its ability to generate sales.
- It enables one to plan inventory storage better and optimise overhead expenses.
- It comes in handy for making an informed investment-related decision.
However, there are several shortcomings, as well. Users must account for them in due advance, to make the most of this financial measure without being subject to its shortcomings.
Limitations of Current Ratio
These are among the most significant drawbacks of the current ratio –
- When used single-handedly, this ratio does not prove efficient to measure the liquidity of a particular firm accurately.
- This ratio is based on the quantitative aspect of current assets and does not weigh its qualitative aspect.
- It factors in a firm’s inventory, which often exaggerates its liquidity out of proportion.
- Often fails to gauge the financial health of a firm accurately as it does not account for the frequency of sales or obsolete produce.
- Companies with seasonal sales often show a discrepancy in their ratio throughout the operating cycle.
- A change in the method of inventory valuation also influences the ratio, which has nothing to do with the financial health or repayment capability of a firm.
- This ratio is relatively easy to manipulate; hence does not provide an accurate picture to investors or stockholders.
Lastly, it can be said that the current ratio, when used with other potent financial indicators, reflects the liquidity of a firm efficiently. Furthermore, it enables investors, stockholders and business owners to gauge the financial health and immediate prospects of the company successfully. Nonetheless, the decision to invest in a company should not be based entirely on liquidity ratios. It should also be based on factors like – one’s age, income, risk-taking capability and financial goals.