Definition of Current Ratio
Looking for Current Ratio Assignment Help? You are at Right Place. Current Ratio, also known as Working Capital Ratio explains the relationship between Current Assets and Current Liabilities of a business. It measures a Company’s ability to pay short term and Long term Obligations. The formulae for calculating current ratio is Current Assets divided by the Current Liabilities.
What do you mean by the term Current Assets and Current Liabilities?
Current Assets are the assets which are likely to be converted into cash or cash equivalents within 12 months from the date of Balance Sheet or within the period of operating cycle. Example of Current Asset are Current Investments, Inventories, trade receivables, Cash and Cash Equivalents etc.
Current Liabilities are the liabilities payable within 12 months from the date of Balance Sheet or within the operating cycle. For Example: Short term Borrowings, Trade Payables, Short term Provisions etc.
Interpretation of Current Ratio
The Current Ratio is mainly used to give an idea of the company’s ability to pay back its liabilities with its assets. It can be used to take a rough measurement of a company’s financial health. The higher the current ratio, the more capable the company is of paying its obligations as the company would be having larger proportion of asset value comparing to the value of its liabilities. The Current Ratio below 1 indicates that a Company’s liabilities are greater than its assets and suggests that the company would not be in a position to pay off its obligations if they became due at that point. The Current Ratio below 1 also indicates that the Company’s financial health is not good. It does not necessarily mean that it will go bankrupt. There are many ways for a company to access financing, and this is particularly so if a company has realistic expectations of future earnings against which it might borrow. For Instance : If a Company has a reasonable amount of Short term Debt but is expecting substantial returns from a project or other investment not too long , after its debt are due , it will likely be able to stave off its debt.
What is an Ideal Current Ratio?
According to accounting principles, a current ratio of 2:1 is supposed to be an Ideal Ratio. It means the Current Assets of a business should, at least be twice of its Current Liabilities. The reason of assuming 2:1 as the ideal ratio is that the Current assets include assets such as Inventory, Trade Receivables etc. from which full amount cannot be realised in case of need. Even if half of the amount is realised from the current assets on time, the business can still meet its current liabilities in full.
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