Current Ratio is also know as Working Capital Ratio
What Is Current Ratio?
At first, The names Current Ratio and Working capital are two different names for the same calculation. We call it Current Ratio, from now on.
Generally, the creditors specially the short term creditors like suppliers and short term security holder in the company are interested to know the short term liquidity position of the company. They use the current ratio to get a guess about this.
Current ratio is a Liquidity ratio that measures the ability of a firm to pay off its short term obligations. This ratio compares company’s short term liabilities to its short term assets. Higher company’s current ratio would show that the company is better able to pay its short term liabilities. Total current assets are divided by the total current liabilities to get this ratio.
How to calculate the Current Ratio?
Current Ratio = Current Assets / Current Liabilities
If the Current Ratio is less then one the have a negative working capital. This can indicate the company may have problems in paying off the short-term obligations. When the Current Ratio is too high, this can indicate that the company may not be efficiently using its Current Assets.
Current Assets are the cash kept by the company and those assets that are readily convertible into cash within the period of one year, like marketable securities, account receivables, inventories and prepaid expenses also named as liquid assets.
Current liabilities show the short term obligations or debts that the company should pay off in theperiod of one year, like accounts payable, short term loans, dividend declaredbut not paid etc.
Current Ratio value:
Current ratio is different for each industry and an average ratio of 1.5to 3 depicts an efficiently performing and good liquid company. Higher current ratio value shows that the firmis not making best use of its available assets but is only concentrating onshort term liquid position; it will be having a more liquidity position though.Although, this higher ratio benefits the short term creditors and investors butis not much beneficial for the firm. The firm should maintain a balance ofliabilities and assets. Low current ratio predicts that firm will be facingdifficulty in meeting its short term obligations.
Significance for the Firm:
- Current ratio is significant to consider as it measures the liquidity positions of the company and management can decide to change different strategies like debt recovering time period and terms, its debt paying time periods and short term investment decisions.
- Generally, firms would try to carry the current ratio till 1. This level of ratio ensures the loan agreement to protect the interest of creditors, if the firms’ debtors are unable to pay at the right time.