Current Ratio

Current Ratio: It shows the relationship between the current assets and current liabilities. It is also known as Working Capital Ratio because it shows the relation between the two components of Working Capital i.e. Current Assets and Current Liabilities.

Current Ratio = Current Assets / Current Liabilities

Before calculating the Current Ratio from the above formula, we have to know about the Current Assets and Current Liabilities.

Current Assets:- These are the assets in a business which can be converted into cash within 12 months within a period of operating cycle. We can include these following items in Current Assets:

·         Current Investments (short term investments, marketable securities)

·         Trade Receivables (Debtors excluding provision created on them and B/R)

·         Cash (in hand, at bank, cheques, drafts in hand)

·         Inventories (excluding loose tools, stores & spares)

·         Short term loans and Advances

·        Other Current Assets (prepaid expenses, accrued incomes, advance taxes)

Current Liabilities:- These are the liabilities of a business which are payable within 12 months within a period of operating cycle. These include the following items:

·         Short term borrowings (including overdraft from banks)

·         Short term provisions (provision for tax, proposed dividends)

·         Trade Payables (Creditors and B/P)

·         Other Current Liabilities (interest accrued on borrowings, income received in advance, outstanding expenses, current maturities of long term debts, calls in advance, unclaimed dividends)

Ideal Ratio:- 2:1

Example: From the following particulars calculate the Current Ratio:

                                                                                   ₹

Current Investments                                                    50,000

Inventories (including loose tools of ₹40,000)                2,90,000

Trade Payables:   

        Sundry creditors                                                  1,10,000

        Bills Payables                                                      20,000

Non-current investments                                              1,00,000

Long term Borrowings                                                  10,000

Trade Receivables:

        Sundry debtors                                                   1,20,000

        Bills Receivables                                                  30,000

Short term Borrowings                                                 50,000

Cash and Bank balance                                                50,000

Provision for Tax                                                         20,000

Solution: Current Ratio = Current Assets / Current Liabilities

So we have to find Current Assets and Current Liabilities first.

Current Assets = Current Investments + Inventories (excluding loose   

                          tools)+Trade Receivables (Sundry debtors + Bills 

                          receivables) + Cash and Bank balance

                      =₹50,000+₹2,50,000+₹1,20,000+₹30,000+₹50,000

                      =₹5,00,000

Current Liabilities = Trade Payables (sundry creditors + Bills Payables) 

                             + Short term Borrowings + Provision for tax

                          =₹1,10,000+₹20,000+₹50,000+₹20,000

                          =₹2,00,000

So, Current Ratio will be 5,00,000 / 2,00,000 = 2.5:1

Ideal Ratio is considered 2:1. In this case the ratio is 2.5:1. So we can say that the short term financial position of the company is satisfactory.

Significance of this Ratio: This ratio tells us about the short term financial position of a company. We can know that a firm is able to meet its short term liabilities on time or not. According to the Accounting Principles, 2:1 Current Ratio is considered as ideal for the firm. It means Current Assets of a firm should be twice of the Current Liabilities.