Definition
The current ratio assesses the ability of a business enterprise to pay liabilities that will fall due within a period of 1 year. These liabilities are known as current liabilities. The sources of funds for paying such liabilities are assets that can be converted into cash within a period of 1 year. These assets are known as current assets.
Calculation of Current Ratio
The ratio is calculated by using the formula: Current Assets / Current Liabilities.
Composition of Current Assets
Current assets include cash and bank balances, marketable investments, sundry debtors, bills receivable, stocks of raw material, work-in-progress, and finished goods, stores & spares, prepaid expenses and loans recoverable within 1 year.
Composition of Current Liabilities
Current liabilities include cash credit/overdraft/export credit from banks, sundry/trade creditors, bills payable, instalments of debts payable within a period of 1 year, outstanding expenses payable and provisions for expenses.
Importance of Current Ratio
Conventionally, banks and financial institutions look at a ratio of 1.33 or more. A low ratio could be indicative of cash crunch being experience by the enterprise. Defaults in meeting current obligations could result in credit becoming costlier, refusal of creditors to supply materials, and, recovery suits.
Interpretation
The analyst should interpret the current ratio in the context of the industry standard / average, the quality of the current assets and the track record of the company.
