Current ratio

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.

A higher current ratio indicates strong solvency position and is therefore considered better.

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:

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:

Some common examples of current assets are given below:

• Cash
• Marketable securities
• Accounts receivables/debtors
• Inventories/stock
• Bills receivable
• Short-term totes receivable
• Prepaid expenses

Some common examples of current liabilities are given below:

Example 1

On December 31, 2016, the balance sheet of Marshal company shows the total current assets of \$1,100,000 and the total current liabilities of \$400,000. Your are required to compute current ratio of the company.

Solution

Current ratio = Current assets/Current liabilities
= \$1,100,000/\$400,000
= 2.75 times

The current ratio is 2.75 which means the company’s currents assets are 2.75 times more than its current liabilities.

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.

Liquidity comparison of two or more companies with same current ratio

We may find situations where two or more companies have the same current ratio figures but their real liquidity position is far different from each other. It happens because of the quality and nature of individual items that make up the total current assets of the companies. Consider the following example to understand this point in more detail:

Example 3

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

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 and when 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 quickly converted into cash.

From this analysis, it is clear that the two companies with same current ratio might have different liquidity position. The analyst should, therefore, not only focus on the current ratio figure but also consider the composition of current assets while determining a company’s real short-term debt paying ability.

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 and/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

In order to overcome these limitations, current ratio may be used in conjunction with some other ratios like inventory turnover ratio, debtors turnover ratio, average collection period ratio, current cash debt coverage ratio, debt to equity ratio and quick ratio etc. These ratios can test the quality of some individual current assets and together with current ratio provide a better idea of company’s solvency.

Example 3 – computation of current liabilities when current assets and current ratio are given

The T & D company’s current ratio is 2.5 : 1 for the most recent period. If total current assets of the company are \$7,500,000, what are total current liabilities?

Solution

Current ratio = Current assets/Current liabilities
2.5/1 = \$7,500,000/Current liabilities
2.5 × Current liabilities = \$7,500,000
Current liabilities = \$7,500,000/2.5
Current liabilities = \$3,000,000

Example 4 – computation of current assets when current liabilities and current ratio are given

If current ratio is 1.5 and total current liabilities are \$500,000, what are total current assets?

Solution

Current ratio = Current assets/Current liabilities
1.5/1 = Current assets/\$500,000
Current assets = 1.5 × \$500,000
Current assets = \$750,000

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16 Comments on Current ratio

1. sahar naz

yes! its useful

2. Raheel

nice useful

3. simon

excellance explanation with a clear example.

4. asakeed aldabu

very good service, much help. thanks you

5. Orepa Posini

Thank you so much, have helped me a lot in a stressful time of assignments. appreciate it.

6. Duri Linda

Thank u very much even Maria Taguta really appreciated it

1. Accounting For Management

Who Maria Taguta?

7. Brittany Peacock

who has written this piece so I can reference it

1. Accounting For Management

It is OK to refer to the site name https://www.accountingformanagement.org. Please provide full URL.

8. Ankit

short term provision is taken while calculating current ratio

9. very much useful. thank you.

10. Meokgo

what formula do i use ti increase debt when the current ration is 2.2:1

11. Emmanuel mwila

this is nice .also talk about the quick ratio

12. Vincent Otti Ocanson

This was really helpful had to give a report and was confuse at a point thanks for the remembrance. thanks to the team .
big ups

13. Daalu

Very clear and prompt explanations with instances. It was a timely help at the needed.

14. saima sattar

Assume that Net Working Capital is positive for a business entity and its current ratio is 1.2 times. How would the following events affect (increase/decrease/no effect) the current ratio of the company. Also provide the conceptual reason behind each effect.

1. Inventory is purchased on credit.
2. Repayment of last installment of a long term loan.
3. A credit customer pays off on a discount of 3%.
4. Improvement in current assets through new equity issue.