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Current Ratio

A current ratio is a method of a company’s short-term solvency-its capability to pay its liability which comes due in the future (up to one year).  The ratio is rough sign of whether cash to be collected from the accounts receivable from the selling inventory and cash on hand will be sufficient to pay off the company liabilities which would come due in the coming or next year.

As you can imagine, lenders are particularly keen on punching in the numbers to calculate the current ratio. Here is how they do it:

Current assets divided by current liabilities is equal to current ratio (current assets / current liabilities =   current ratio).

However, unlike most other financial ratios, you don’t multiply the results of this equation by 100 and represent it as a percent.

Businesses generally have to maintain two to one current ratio that means its current assets have to be double the current liabilities it has. In fact, a business may be legally required to stay above a minimum current ratio as stipulated in its contracts with lenders. Let’s take an example; a business has 136,650,000 dollars in current assets and 52,855,000 in current liabilities, so its current ratio is 2.3. It should not have to worry about lenders coming by in the middle of the night to break its legs.

Many of the serious investors and lenders don’t stop with the current ratio for testing the business's short-term solvency (its capability to pay the liabilities that will come due in the short term)    . Investors and especially lenders calculate the acid-test ratio, which is also known as quick ratio or pounce ratio, which is more severe test of a business's solvency than the current ratio. The acid-test ratio excludes inventory and prepaid expenses, which the current ratio includes, and it limits the assets to items and cash and which the firm could convert into cash quickly. This limited category of assets is called as liquid or quick assets.

Questionnaire:

• What is current ratio and give the formula for calculating current ratio
• What are the uses of current ratio?

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