The current ratio compares current assets to current liabilities for enterprises. A higher current rate indicates greater liquidity (more ability to meet short-term obligations), and a lower current ratio indicates a less nimble company.
The formula is:–
Current ratio = current assets / current liabilities
A current ratio of 1.0 would indicate that the book value of current assets is equal to the book value of current liabilities.
Current assets are assets that can be converted into cash or be utilized within 12 months.
Items that come under the head current assets are:
- Accounts receivables
- Short term debtors
- Marketable securities
- Cash & cash equivalents
- Other current assets
Current liabilities are liabilities that are to be paid within 12 months, such as accounts payable, outstanding bills, and expenses.
The current ratio is also called the crude ratio, as it measures only the quantity and not the quality of current assets. For ex: – There can be a high amount of current assets due to large amounts of unsold inventory, which is stuck or not fit for sale in the market, or there is no demand in the market. This will increase the current assets hampering the liquidity position of the company.
What is an Ideal Current ratio?
An ideal current ratio is 2:1, that represents that the current assets are enough to pay off the current liabilities. A higher current ratio is not intended as it shows that the assets are not invested judiciously so as to generate high returns.
How to interpret the current ratio?
A current ratio of 1.5 means that for every Rs. 1 in current Liabilities, the company has Rs 1.50 in current assets. Consider the scenario when a corporation has Rs 50,000 in cash and Rs 1,00,000 in accounts receivable as its current assets. Meanwhile, it has Rs 1,00,000 in accounts payable as current liabilities. By dividing the company’s current assets (Rs 1,50,000) by its current liabilities (Rs 1,00,000), one may determine that it has a current ratio of 1.5.