Financial Analysis Current Ratio Current ratio is a vital liquidity ratio. It measures the liquidity position of a company. It is useful not only to the internal finance manager but equally useful to creditors, lenders, banks, investors etc. It is simple but incredibly useful information for financial analysts. Low current ratio is direct sign of high risk of bankruptcy and too high current ratio impacts the profits adversely. Current Ratio Current Ratio Current ratio is one of the liquidity ratios calculated to manage or control liquidity position of a company. At the outset, the point of thinking is that why do we need to manage liquidity position. Essentially, liquidity of a company refers to its ability to honor its creditors or other vendors.Now, liquidity position just assumes a position similar to a scale with cost of funds on one end and risk of bankruptcy on the other end. If we keep lower than required funds, probability of dishonoring our dues is too high. On the contrary, if we keep abundant funds, cost of funds (in the form of interest cost) would reduce the profits. So, a balanced situation is very much desirable as far as liquidity is concerned. How to calculate current ratio? Calculation of current ratio is very simple. It is just a ratio of current asset to current liabilities. Sometimes, these figures are readily available but at times, they are to be determined using the financial statements of the company. Ratio is stated as follows: Current Ratio = Current Assets Current Liabilities Current Assets: Current assets include all those items which are either cash or can be converted into cash in a short while. This period is generally considered a year. Although following list cannot be a comprehensive but we have tried to cover most of them. Current Assets include following items: Inventory / Stock Debtors and Bills Receivables Cash and Bank Balances Short Term Loans Marketable Investment / Short Term Securities Current Liabilities: Same is the case with current liabilities. Current liabilities are those liabilities which are payable in a year’s time. Current Liabilities include following items: Sundry Creditors Outstanding Expenses Short Term Loans and Advances Bank Overdraft / Cash Credit Provision for Taxation Proposed Dividend Unclaimed Dividend Interpretation of current ratio: In the current ratio, increase in numerator (current assets) increases the ratio and vice versa whereas increase in denominator (current liabilities) decreases the ratio and vice versa. A current ratio of 2:1 is considered a lenient liquidity position and 1:1 would be too tight. A current ratio of 1.33:1 forms the base requirements of banks before sanctioning any working capital finance. Current ratio is utilized by both internal managers of the company to analyze its financial position and take corrective action if need be. Investors or borrowers like banks or financial institutions utilize it to decide upon the health of company and take decisions such as sanction of loans their respective amounts etc. Creditors look at the current ratio of a company to evaluate whether it will be able to pay the dues on time or not. Effective management of liquidity leads to improvement in profitability and thereby the wealth of the investors. Good bargain with creditors with regards to credit period and control on the credit period of debtors can improve the overall liquidity position of a company and lowering down the cost of funds to finance working capital.
Posted on: Sat, 12 Jul 2014 13:45:36 +0000
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