Current ratio (also known as working capital ratio) is a popular tool to evaluate short-term solvency position of a business. Short-term solvency refers to the ability of a business to pay its short-term obligations when they become due. Short term obligations (also known as current liabilities) are the liabilities payable within a short period of time, usually one year.

Formula

Current ratio is computed by dividing total current assets by total current liabilities of the business. This relationship can be expressed in the form of following formula or equation:

current-ratio-formula

Above formula comprises of two components i.e., current assets and current liabilities. Both the components are available from the balance sheet of the company. Some examples of current assets and current liabilities are given below:

Current assets Current liabilities
Cash Accounts payable / creditors
Marketable securities Accrued payable
Accounts receivables / debtors Bonds payable
Inventories / stock
Prepaid expenses

Example 1

Compute the current ratio from the following balance sheet of X Ltd:

Liabilities $ Assets $
Share capital (fully paid up) 1,000,000 Land and building 1,000,000
General reserve 800,000 Plant and machinery 400,000
Profit and loss account 300,000 inventory 300,000
Accounts payable 400,000 Accounts receivables 500,000
Cash and bank balances 300,000
———- ———-
2,500,000 2,500,000
———- ———-

Solution

current-ratio-formula

= 1,100,000* / 400,000**

= 2.75 times

*Current assets:   **Current liabilities:
Stock 300,000   Sundry creditors 400,000
Sundry debtors 500,000
Cash 300,000
——— ———
Total current assets of X Ltd 1,100,000   Total current liabilities of X Ltd 400,000
——— ———

Significance and interpretation

Current ratio is a useful test of the short-term-debt paying ability of any business. A ratio of 2:1 or higher is considered satisfactory for most of the companies but analyst should be very careful while interpreting it.  Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio may not always be a green signal. It requires a deep analysis of the nature of individual current assets and current liabilities. A company with high current ratio may not always be able to pay its current liabilities as they become due if a large portion of its current assets consists of slow moving or obsolete inventories. On the other hand, a company with low current ratio may be able to pay its current obligations as they become due if a large portion of its current assets consists of highly liquid assets i.e., cash, bank balance, marketable securities and fast moving inventories. Consider the following example to understand how the composition and nature of individual current assets can differentiate the liquidity position of two companies having same current ratio figure.

Example 2

The following data has been extracted from the financial statements of two companies – company A and company B.

Company A Company B
Current assets:
Cash $50,000 $4,000
Accounts receivable 120,000 16,000
inventory 170,000 320,000
Prepaid expenses 10,000 10,000
———— ————
Total current assets (a) 350,000 350,000
———— ————
Current liabilities (b) 175,000 175,000
———— ————
Current ratio (a)/(b) 2:1 2:1
———— ————

Both company A and company B have the same current ratio (2:1). Do both the companies have equal ability to pay its short-term obligations?

The answer is no. Company B is likely to have difficulties in paying its short-term obligations because most of its current assets consist of inventory. Inventory is not quickly convertible into cash. The company A is likely to pay its current obligations as they become due because a large portion of its current assets consists of cash and accounts receivables. Accounts receivables are highly liquid and can be converted into cash quickly.

From this analysis, it is clear that the analyst should not only see the current ratio but also the composition of current assets.

Limitations of current ratio

Current ratio suffers from a number of limitations. Some are given below:

  1. Different ratio in different parts of the year:
    Some businesses have different trading activities in different seasons. Such businesses may show low current ratio in some months of the year and high in others.
  2. Change in inventory valuation method:
    To compare the ratio of two companies it is necessary that both the companies use same inventory valuation method. For example, comparing current ratio of two companies would be like comparing apples with oranges if one uses FIFO cost flow assumption and the other uses LIFO cost flow assumption for the valuation of inventories. The analyst would, therefore, not be able to compare the ratio of two companies even in the same industry.
  3. Current ratio is a test of quantity, not quality:
    It is not an exact science to test liquidity of a company because the quality of each individual asset is not taken into account while computing this ratio.
  4. Possibility of manipulation:
    Current ratio can be easily manipulated by equal increase or equal decrease in current assets and current liabilities. For example, if current assets of a company are $10,000 and current liabilities are $5,000, the current ratio would be 2:1 as computed below:
    $10,000 : $5,000
    2:1
    If both current assets and current liabilities are reduced by $1,000, the ratio would be increased to 2.25:1 as computed below:
    $9,000 : $4,000
    2.25:1

To reduce the effect of above limitations current ratio is usually used in conjunction with other ratios like inventory turnover ratio, debt to equity ratio and quick ratio etc. These ratios can test the quality of current assets and together with current ratio provide a better idea of solvency.