Current Ratios: This ratio is an indicator of the firm’s commitment to meet its short-term liabilities. It is expressed as follows:
Current assets mean assets that will either be used up or converted into cash within a year’s of time or normal operating cycle of the business, whichever is longer. Current liabilities means liabilities payable within a year or operating cycle, whichever is longer, out of existing current assets or by creation of current liabilities. A list of items include in current assets & current liabilities has already been given in the performs analysis balance sheet in the preceding chapter.
Book debts outstanding for more than six months & loose tools should not be included in current assets. Prepaid expenses should be taken as current assets.
An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of solvency due to the fact that if the current assets are reduced to half, i.e., 1 instead of 2, then also the creditors will be able to get their payments in full. However a business having seasonal trading activity may show a lower current ratio at a creation period of the year. A very high current ratio is also not desirable since it means less efficient use of funds. This is because a high current ratio means excessive dependence on long-term sources of raising funds. Long-term liabilities are costlier than current liabilities & therefore, this will result in considerably lowering down the profitability of the concern.
It is to be noted that the mere fact current ratio is quite high does not mean that the company will be in position to meet adequately its short-term liabilities. In fact, the current ratio should be seen in relation to the component of current assets & liquidity. If a large portion of the current assets comprise obsolete stocks or debtors outstanding for a long term, time, the company may fail even if the current ratio is higher then 2.
The current ratio can also be manipulated very easily. This may be done either by either postponing certain pressing payments or postponing purchase of inventories or making payment of certain current liabilities.
Significance: The current ratio is an index of the concern’s Financial stability since it shows the extent of working capital which is the amount by which the current assets exceed the current liabilities. As stated earlier, a higher current ratio would indicate inadequate employment of funds while a poor current ratio is a danger signal to the management. It shows that business is trading beyond its resources.
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