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How to Calculate Current Ratio?
What is Current Ratio?
The correct way to measure the current ratio is to divide current assets by current liabilities.
$$\mathrm{Current\: Ratio\:=\:\frac{Current\: Assets}{Current\: Liabilities}}$$
Here, current assets include items that are short-term in nature. Both assets and liabilities in the current ratio are meant for items that exist within one year from the date of calculation. As the current ratio is a measure of the short-term solvency of a firm, items that are valid beyond one year are not considered in the calculation.
Current Assets
Current assets in the calculation of the current ratio include cash and cash equivalents, and items that can be converted to cash within a term of one year.
Marketable securities, debtors, and inventories are also included in current assets. All of the items that will be paid in the short-term future are included in current assets.
Current Liabilities
Current liabilities include all obligations of the firm that need to be met within a year.
The items that are considered current liabilities are bills payable, creditors, short-term bank loans, accrued expenses, income tax liabilities, and the portion of long-term debt that is payable within a year.
While indicating the short-term solvency, the current ratio indicates the presence of current assets in rupees for every rupee of current liabilities. A ratio of more than one in current ratios means a firm has more assets than liabilities usable in the shorter term.
Interpretation of Current Ratio
Finance professionals consider the following points to interpret the current ratio of a company −
Ratio of 2:1
There is a common understanding among finance professionals to consider a ratio of 2:1 as a satisfactory measure of the current ratio. The conventionality is based on the fact that even if the current ratio gets halved during worsening conditions, it will still be satisfactory for the firm to pay back the debt.
Margin of safety
There is a margin of safety associated with the current assets. The more the margin between current assets and current liabilities, the better the margin and the better it is for the creditors. The greater the margin of safety, the lesser the risk associated with the project, and the better it is to repay the debt back to lenders.
Matter of Quantity Not Quality
Although 2:1 is considered a hallmark in the case of current, it is not mandatory for the firms to have such a ratio. There are enough examples where firms have current ratios quite below 2:1 and they are still performing well while companies with a current ratio of 2:1 may be performing unsatisfactorily. This is due to the fact that the current ratio is a matter of quantity and not quality.
The current ratio considers only the rupees of current assets to every rupee of current liabilities. It does not show or consider the quality of the assets. In the case of current liabilities, their value is fixed and they must be repaid. However, the value of the current assets may fall (change) and they are not fixed like current liabilities.
Financial Strength Not Justified by Current Ratio
If a firm’s assets include slow-moving goods and doubtful stock, the ability of the firm to repay the bills may be compromised. Similarly, when a company has an obsolete stock of goods that takes enough time to materialize into cash, the short-term solvency of the firm may be threatened.
Therefore, too much reliance on the current ratio to judge the company’s financial strength is not justified. Additional exposure of items in current assets should be made in the case the more appropriate value of the current ratio is deserved.
Conclusion
The current ratio is a quick and sufficiently dependable measure to assess the short-term solvency of a firm. It offers an informed insight into the immediate future of a firm’s financials. However, making decisions depending only on current assets may not be appropriate. So, caution must be taken in using it for determining the condition of a firm in the near future.
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