Liquidity ratios measure a company’s ability to settle its short-term obligations. The current ratio is one such ratio. This article explores the current ratio and its practicality.
While determining a company’s solvency, you can use many liquidity ratios. The current ratio is one of them. The current ratio evaluates the all-around financial health of a company. Here is how to calculate and use it.
Current ratio
One of the liquidity ratios, the current ratio, measures the ability of a company to pay its short-term obligations (obligations to be paid within one year). It helps investors and analysts determine ways to maximize its current assets on its balance sheet to suffice its current debt and other short-term obligations.
A current ratio that conforms to the industry average or is somewhat higher than the industry average is usually considered acceptable. But, a current ratio lower than the industry average indicates a higher risk of default in most cases.
The current ratio is called current because it takes all current assets and current liabilities into account. It is also denoted as the working capital ratio because when a company has more current assets than its current liabilities, it also suggests that it has sufficient working capital for its day-to-day operations.
Calculating the current ratio of a company
While calculating the current ratio, a company’s current assets are compared to its current liabilities.
Current assets are to be consumed or converted to cash within 1 year. These assets may include cash, bank deposit, marketable securities, accounts receivable, inventory, prepaid expenses, short-term loans & advances, and other current assets (OCA). On the other hand, current liabilities will be paid in 1 year. These liabilities may include accounts payable, short-term loans, cash credit, overdraft, advance from the customer, outstanding expenses (rent, salary, wages, etc.), and long-term loan instalments.
Current Ratio = Current liabilities/Current assets
Current ratio analysis of a company
Current ratio analysis is conducted to determine the liquidity of a company. Subsequently, the current ratio analysis results can be considered to give loans or make investment decisions. Also, the current ratio can decide if a company should be shut down.
A company having a current ratio lower than 1.33 lacks capital on hand to meet its short-term obligations if all have to be paid at once. In other words, it is likely to face problems in paying its short-term loans and obligations. A current ratio greater than 1.33 suggests that the company has sufficient financial resources to maintain its solvency in the short term. In short, it can settle its debt and other short-term obligations comfortably.
A current ratio under 1.33 suggests that the company’s debts to be paid in a year or less are much more than its current assets.
The ideal ratio of current assets and current liabilities
A decent current ratio depends on the company’s industry and its historical performance. As a thumb rule, a current ratio of more than 1.33 is considered an ideal current ratio as it indicates ample liquidity. All industries in India reported a median current ratio of 1.94 in 2020.
Here we can take an example of Tata Consultancy Services.
Tata Consultancy Services carries a current ratio of 2.92. This means that it has ₹ 2.92 of current assets for every ₹ 1.00 of current liabilities. So, Tata Consultancy Services is substantially capable of paying its obligations as it has a larger proportion of short-term assets compared to its short-term liabilities.
Effects of an imbalanced current ratio of a company
If current liabilities exceed current assets, the current ratio will be less than 1.33. A current ratio of less than 1.33 indicates that the company may have problems meeting its short-term obligations. In other words, the company has less than 1.00₹ of current assets for every 1.00₹ of current liabilities.
This can be understood with the help of an example.
Vodafone Idea has a current ratio of 0.29. This means that it has ₹ 0.29 of current assets for every 1.00₹ of current liabilities. So, Vodafone Idea may not be capable of meeting its obligations as it has a much smaller proportion of short-term assets compared to its short-term liabilities.
As the current ratio is the ratio of current liabilities to current assets, when a company’s current ratio is imbalanced, i.e., less than 1.33, this means the company has relatively more liabilities than its assets. Some possible effects could be:
- The company may face problems in the short term for paying its short-term obligations, such as salary to workers, office rent, etc.
- The company may have to raise additional financing, such as taking out a loan.
- The company becomes more likely to face liquidity risk.
- The company may have to take long-term funds in equity and/or long-term debt.
The more current assets you have, the better the chances that the company will settle its current liabilities.
The Bottomline
If the current ratio is higher, the company is more capable of paying its obligations because it has a larger proportion of short-term assets than its short-term liabilities. The current ratio is a useful measure of a company’s short-term solvency. It also provides more valuable insight if calculated regularly over several periods.
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