Current ratio
Meaning: this ratio establishes a relationship among current assets and current liabilities.
Objective: the objective of computing these ratios is to calculate the ability of the firm to meet its short term obligation and to reflect the short term financial strength/solvency of a firm. In other words the objective is to measure the safety margin available for short term creditors.
Components: The are two components of this ratio which area under:
a) Current assets: which mean the assets which are held for their conversion into cash within a year and include the
b) Current liabilities: current liabilities are those obligation which are payable within a short period of generally one year and include the
Computation: this ratio is commuted by dividing the current assets by the current liabilities. This ratio is usually expressed as a pure ratio for example 2:1. In the form of a formula this ratio may be expressed as under:
Interpretation of current ratio
A relatively high current ratio is an indication that the firm firm is liquid and has the ability to pay its current obligations in time as and when they become due. On the other hand a relatively low current ration represent that the liquidity position of the firm is not goods and the firm shall not be able to pay its current liabilities in time without facing difficulties. A ratio equal or near to the rule of thumb of 2:1 i.e. current assets doubled the current assets. Though the rule of 2:1 should not be blindly followed while making interpretation of the ratio may be having a better liquidity than even firm having more than 2:1 ratio. This is so because the current ratio measures only the quantity of current assets and not quality of current assets.
A high current ratio may not be favorable due to the following reasons:
There may be slow moving stocks. The stocks will pile up due to poor sale
The figures of debtors may go up because debt collection is not satisfactory
The cash or bank balance may be lying idle because of insufficient investment opportunities
On the other hand a low current ratio may be because of the following reasons:
There may not be sufficient funds to pay off liabilities
The busing mess may be trending beyond its capacity. The resources may not warrant the activities