Meaning of Current Ratio
The current ratio is the most widely used liquidity ratio which will help you to evaluate the short-term solvency of the business.
If you are a creditor or lender of the organization, you can use the Current ratio to evaluate the repayment ability of the business, and also it will help Owners to determine how efficiently the organization can utilize its current Assets to repay the current liabilities and other payables.
The current ratio is the most common measure of short-term liquidity.
The formula for Current Ratio
Current Ratio = Current Assets / Current liabilities
For the above formula, Current assets consist of the aggregate value of the following items;
- Accounts Receivables
- Inventories (Stock of goods)
- Cash Balance
- Bank Balance
- Loans and advances
- Disposable investments
- Any other current assets
Whereas, Current liabilities consist of the aggregate value of the following items;
- Accounts Payables / Creditors
- Bank Overdraft
- Short-term loans
- Outstanding expenses
- Tax provisions
- Proposed dividend
- Unclaimed dividend
- Any other current liabilities
Standard/ Ideal Current Ratio
Generally, a current ratio of 2 to 1 is considered optimal for the organization (i.e. Current assets of the firm are twice that of current liabilities). However, the current ratio of an organization is satisfactory depends on many factors such as the nature of business and also the quality of Current assets and liabilities of the organization.
For example, some organizations may have a very high current ratio. However, the majority of the value of current assets consists of Account Receivables having very high aging or it can consist of Inventories of goods that are obsolete.
Significance of Current Ratio
Now you might be thinking that the higher the current ratio better it is for the organization. However, this is not true if the organization has a very high current ratio it will have an adverse impact on the profitability of the organization. A higher current ratio means the organization may have blocked a higher amount of capital in Inventory or debtor collection process is inefficient, high balance in cash and bank accounts without proper investments.
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