Current Ratio is ratio between Current Assets and Current Liabilities. It compares Current Assets with Current Liabilities of the business.
Current Ratio is about a business’s liquidity. Liquidity is the ability of a business to pay its short-term debts – its access to cash. If a business does not have enough cash to pay for its immediate expenses (or short-term debts), it will not be able to continue trading. Therefore, liquidity is important to a business’s survival and smooth daily operations. Hence, it must be carefully managed at all times.
What does Current Ratio measure?
Current Ratio deals with a firm’s liquid assets and Short-term Liabilities – its Working Capital used to run daily operations. It reveals whether a firm is able to cover its short-term debts using its liquid assets.
Current Assets represent things owned by the business which are already in the form of Cash, or which are easy to be converted into cash within the next 12 months. Current Assets are important to a business because they indicate how much cash a business has access to in order to meet its short-term obligations. Current Liabilities are the short-term debts of a business, which are expected to be paid in the near future within the next 12 months.
It is important that the level of Current Assets is greater than the level of Current Liabilities. Otherwise, the business risks liquidity problems – not having enough cash to pay its short-term debts, nor any spare cash for unexpected daily expenses.
Current Ratio measures whether a business is able to cover its short-term debts using its Current Assets which are liquid assets.
How to calculate Current Ratio?
The figures for working out Current Ratio can be found in Balance Sheet:
| Current Assets | |||
| Current Ratio = | ━━━━━━━━━━━━━━━━━━━━ | ||
| Current Liabilities |
Current Assets include Cash, Debtors (Accounts Receivable) and Inventories.
Current Liabilities include Overdraft, Creditors (Accounts Payable), Short-term Loan, TAX and Dividends.
Comment
Current Ratio is expressed as a number.
A ratio of 2 implies that the firm has USD$2 of Current Assets to cover every USD$1.00 of Current Liabilities.
Proper Current Ratio: Current Ratio between 1.5 and 2 which is generally safe. There is no particular result that can be considered a universal guide to a firm’s liquidity – much depends on the industry. Current Ratio should be no less than 1.5, otherwise there is a risk of running out of cash. The firm might experience working capital difficulties, or even a liquidity crisis. Liquidity crunch is a situation where a firm is unable to pay its short-term obligations. Current Ratio should be no greater than 2 since this suggests that the business has too much cash tied up in unprofitable assets. Potential lenders, suppliers and investors are likely to be interested in a firm’s Current Ratio to reduce the exposure of risk, since this ratio measures the ability of a firm to cover short-term debts with its Current Assets.
Too low Current Ratio: If Current Ratio is below 1, then the short-term debts of the business are greater than its Current Assets. This could jeopardize survival of the business, if all creditors demand payment at the same time. A low ratio might lead to corrective management action to increase cash held by the business.
Too high Current Ratio: A Current Ratio above 2 suggests that there is too much Cash, too much Debtors (Accounts Receivable) and too much Inventories – too many funds are tied up in unprofitable assets. Cash could be better spent to generate more sales, too many debtors increase the likelihood of bad debts while too much stock increases storage and insurance costs. These assets should be better placed to increase efficiency.
Example for Current Ratio
COMPANY A
Company A has Current Assets of USD$1,500,000 and Current Liabilities of $1,000,000 in 2020. In 2021, Company A has Current Assets of USD$1,600,000 and Current Liabilities of USD$800,000.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Current Assets | $1,500,000 | $1,600,000 | |||||
| Cash | $1,000,000 | $600,000 | |||||
| Debtors (Accounts Receivable) | $300,000 | $900,000 | |||||
| Inventories | $20,000 | $100,000 | |||||
| Current Liabilities | $1,000,000 | $800,000 | |||||
| Overdraft | $100,000 | $50,000 | |||||
| Creditors (Accounts Payable) | $500,000 | $450,000 | |||||
| Short-term Loan | $250,000 | $200,000 | |||||
| TAX | $100,000 | $100,000 | |||||
| Dividends | $50,000 | $0 | |||||
| Current Ratio | 1.5 | ➚ | 2 |
For every USD$1 of Current Liabilities, Company A has USD$1.5 of Current Assets in 2020. In 2021, for every USD$1 of Current Liabilities, Company A has USD$2 of Current Assets. This means that the company is more liquid in 2021 comparing with 2020 as it has access to more liquid assets such as Cash, Debtors (Accounts Receivable) and Inventories to meet its Short-term Liabilities and pay any unexpected expenses. The company is showing an improvement in liquidity.
How to improve Current Ratio?
Current Ratio can be improved by a combination of raising the value of Current Assets as well as reducing the value of Current Liabilities.
Ideally, the business wants to increase its Cash. However, there is also a potentially large opportunity cost in holding too much Cash.
- Increase Cash:
- Sell off Fixed Assets. Unused land and buildings as well as redundant equipment could be sold. The business could also lease them back, if still needed. However, leasing charges will add to Expenses (Overheads) and reduce Net Profit Margin (NPM). If Fixed Assets are sold quickly, they might not raise their true value.
- Increase long-term loans to inject cash into the business. Long-term bank loans could be taken out, if the bank is confident of the company’s prospects. However, these will increase interest costs and Gearing Ratio.
- Sell shares. New investors will inject much-needed cash into the business in exchange for partial ownership.
- Delay payments to Creditors. It might be possible to negotiate delayed payment to creditors with whom the business has trustworthy relationship.
Can the firm increase Debtors (Accounts Payable)? It can be dangerous for a firm to increase Debtors (Accounts Payable) since this increases the likelihood of bad debts.
Can the firm sell inventories? Selling inventories for cash will not change anything in Current Ratio as both belong to Current Assets.
2. Decrease Current Liabilities:
Hence, it is more practical for a business to reduce its Short-term Liabilities.
- Decrease Overdraft. Convert Overdraft with very high interest into long-term debt that offers more attractive rates of interest. However, this option may affect the long-term liquidity of the firm.
- Decrease Creditors (Accounts Payable). Temporarily halt purchasing new Inventories using trade credit.
- Decrease Short-term Loan. Convert short-term bank loans with high interest into long-term debt that offers more attractive rates of interest. However, this option may affect the long-term liquidity of the firm.
- Decrease TAX.
- Decrease Dividends. Cancel or reduce the cash that is paid out to shareholders in the form of a dividend. Instead of transferring the cash to shareholders, the business can keep it to improve Current Assets.
