What is current ratio?
It is otherwise called as working capital ratio. Current ratio may be defined as the relationship between current assets and current liabilities. Current ratio calculates the general liquidity of the business concern.
Formula to calculate current ratio
The following formula is used to calculate current ratio.
In this formula, the current assets and current liabilities should be calculated in order to find the current ratio. The term current assets includes the following items.
- Cash in Hand.
- Cash at Bank.
- Short Term Investment.
- Marketable Securities.
- Fixed Deposits with Banks (Maturing within one year).
- Bills Receivable.
- Stock of Raw Materials.
- Materials order in transit.
- Work in Progress.
- Stock of Finished Goods (including goods in transit).
- Consumable Stores.
- Advance Payment of Tax.
- Prepaid Expenses.
- Receivables arising out of sales.
- Deferred Receivables (including bills purchased and discounted by bankers) Installments due within one year.
- Advances for purchase of raw materials, components and consumable stores.
- Deposits kept with public bodies for normal business operation (Example: Earness Deposit kept by construction companies maturing within one year).
- Sundry Debtors.
- Accrued Income.
- Money receivable from contracted sale of fixed asset during the next 12 months.
The term current liabilities include the following items.
- Short term borrowings.
- Unsecured loan payable within a year.
- Public Deposits Maturing within a year.
- Sundry Creditors.
- Interest and other charges due for payment.
- Outstanding Expenses.
- Bills Payable.
- Advances Received from customers.
- Bank overdraft (if temporary arrangement made with bank).
- Provision for Taxation.
- Proposed Dividend.
- Deposits Received from Dealers and Agents.
- Amount Payable for redeemable debentures and preference shares (within a year).
- Statutory Liability.
- Provident Fund due within one year.
- Bills purchased and discounted from banks.
- Installments due on term loans.
- Long term deposits payable within one year.
- Gratuity payable within one year.
If there is no indication of bank overdraft as permanent arrangement or temporary arrangement, the bank overdraft is taken as current liabilities.
In nutshell, current asset means cash and assets which are convertible into cash within one year. Current liabilities means any obligations (both short term and long term) which are payable within one year.
Significance of Current Ratio
We can determine the short term liquidity of a business concern using the Current ratio. An increase in the current ratio represents improvement in the liquidity position of a business concern and wise versa. As a banker’s rule of thumb, the standard for current ratio is 2:1.
Reasons of High Current Ratio
- There may be slow moving of stocks.
- It indicates poor sale.
- The amounts collected from debtors is not satisfactory.
- More cash balances are kept idle in banks.
- Lack of short term investment opportunities.
Reasons of Low Current Ratio
- No sufficient funds to pay of its liabilities in time.
- The business may be operating beyond its capacity.
- The resources of the business concern cannot be properly utilized.
Limitations of Current Ratio
An analyst should be very careful while using the current ratio to find out short term solvency. The reason is that the ratio is suffering from the following limitations.
1. Crude Ratio: It measures the money value of current assets and current liabilities and not the quality of current assets.
2. Window Dressing: Window dressing is the showing of current assets and current liabilities in a better manner than what it is actually. The window dressing is made in the following ways.
- Over valuation of Closing Stock.
- Obsolete items are valued at their cost price instead of writing them off.
- Recording in advance cash receipts as cash sales and these sales are applicable to the next year.
- Underestimation of liability.
- Inadequate provision for doubtful debts.
- Omission of a liability for materials included in the closing stock.
- Treatment of Short term liability as long term liability.
- The advance payment for purchase of fixed assets included in debtors.
Weighted Current Ratio
Under current ratio, all the current assets are valued equally in terms of money value. Moreover, each component of current assets can be converted into cash without suffering any monetary loss. But, in actual practice, there may be some monetary loss if the current assets are sold in an urgency manner. Besides, all types of current assets are not equally liquid and all current liabilities are not repayable with the same degree of quickness.
Formula to calculate weighted current ratio
The following formula is used to calculate weighted current ratio.
Time Adjusted Current Ratio
The value of money received today is more than the value of money received tomorrow. Hence, it is better to give some importance to the day at which the amount is received. Various current assets and liabilities can be adjusted for time value of money by multiplying with the discount factor. The Discount Factor is calculated with the help of following formula.
Where, D.F. = Discount Factor.
r = Discount rate i.e. Annual Earnings.
n = Time taken for each current asset and current liability to be converted into cash.
The following formula is used to calculate Time Adjusted Current Ratio.
Time Adjusted Current Ratio = Time Adjusted Value of Current Assets / Time Adjusted value of current liabilities