📊 Current Ratio
Understanding Your Business's Short-Term Financial Health
Today we're going to learn about a very important liquidity ratio called Current Ratio. This ratio is essential for understanding any business's short-term financial position. Let's dive in and make it super easy to understand! 🎓
🔍 Understanding Ratio Analysis
Ratio Analysis is a crucial part of understanding a business's health. We can classify financial ratios into four main groups:
1. Liquidity Ratios
Assess short-term financial position. Can the business pay its debts due within one year?
2. Solvency Ratios
Assess long-term financial position. Can the business pay debts due after 3-5 years or more?
3. Turnover Ratios
Check if the business is working efficiently and using its assets properly.
4. Profitability Ratios
Study how much profit the business is earning from its operations.
📌 Important Note
Current Ratio, which we're studying in this lesson, is part of Liquidity Ratios. It helps us understand if a business can easily pay its short-term debts!
💡 Why Study Liquidity Ratios?
Liquidity Ratios tell us whether a business can easily pay its short-term debts, short-term liabilities, or loans without any financial stress.
Current Ratio
Considers all current assets
Quick Ratio
Considers only quickly convertible assets
Both ratios measure how easily a firm can convert its assets to cash to pay off short-term debts.
💧 What Does "Liquidity" Mean?
Liquidity means how quickly an asset can be converted into cash. The faster an asset can become cash, the more liquid it is!
Liquidity Scale - From Most Liquid to Least Liquid:
💵 Cash in Hand
Already cash!
Most Liquid
🏦 Cash at Bank
Need to withdraw
Very Liquid
👥 Debtors
Wait for credit period
Moderately Liquid
📦 Stock
Sell first, then get money
Less Liquid
🏢 Building
Takes longest to sell
Least Liquid
📈 What is Current Ratio?
Current Ratio expresses the relationship between Current Assets and Current Liabilities. It measures a firm's ability to pay off short-term debts using all its short-term assets.
📊 Example:
If Current Ratio is 2:1, this means: For every ₹1 of current liabilities, the firm has ₹2 of current assets. This shows good financial health!
✨ Key Insight
Generally, a higher current ratio is better! It indicates good liquidity and financial safety. The business can easily meet its short-term obligations.
📋 Balance Sheet Relationships
Before we calculate Current Ratio, let's understand the basic Balance Sheet relationships:
Shareholder Funds + Non-Current Liabilities + Current Liabilities = Total Liabilities
Non-Current Assets + Current Assets = Total Assets
Total Liabilities = Total Assets
Non-Current Liabilities + Current Liabilities = Total Debts
🔢 How to Calculate Current Liabilities
Sometimes Current Liabilities are not directly given. Here are three methods to calculate them:
Method 1: Using Total Liabilities
Start from total liabilities and subtract what's not current!
Method 2: Using Total Debt
If total debt is given, just subtract the long-term portion!
Method 3: Using Total Assets
Since Total Assets = Total Liabilities, we can use assets side data too!
🔢 How to Calculate Current Assets
Similar to Current Liabilities, we have methods to calculate Current Assets:
Method 1: Using Total Assets
Simply subtract long-term assets from total assets!
Method 2: Using Total Liabilities
Since Total Liabilities = Total Assets, we can use this formula too!
💼 Understanding Working Capital
Working Capital is another important concept related to Current Ratio. It shows how much short-term assets exceed short-term liabilities.
✨ What Does Positive Working Capital Mean?
If Working Capital is positive, it means the firm can easily pay its short-term debts. There's enough cushion to handle financial obligations comfortably!
Related Formulas:
To Find Current Assets:
To Find Current Liabilities:
📝 What's Included in Current Liabilities?
Current Liabilities are obligations that need to be paid within one year or the business's operating cycle. Here are the main components:
💳 Short-term Borrowings
Loans that need to be repaid within a short period (less than one year)
🛒 Trade Payables
Money owed to suppliers for goods purchased on credit. Usually paid within days or months
📊 Short-term Provisions
Expected liabilities where the exact amount is uncertain, but payment may be required soon
📋 Other Current Liabilities
Any other short-term obligations not covered in the above categories
📝 What's Included in Current Assets?
Current Assets are resources that will be converted to cash within one year or the business's operating cycle. Here are the main components:
📈 Current Investments
Short-term investments made for up to one year that can be quickly sold
📦 Inventories (Stock)
Goods that the business deals in. For example, cloth in a clothing store
👥 Trade Receivables
Money that customers owe us from credit sales. We're waiting to collect payment
💵 Cash and Cash Equivalents
Cash in hand, bank balance, and other highly liquid assets
💰 Short-term Loans & Advances
Money we've lent to others for a short period that will be repaid soon
📋 Other Current Assets
Any other assets that will convert to cash within one year
⭐ What's the Ideal Current Ratio?
The Ideal Current Ratio is 2:1
This means for every ₹1 of current liabilities, the business should have ₹2 of current assets. This ratio is considered healthy and shows good short-term financial position! 💪
✅ High Current Ratio (Good)
• Better ability to pay debts
• Strong financial safety
• Good liquidity position
• Less financial stress
⚠️ Low Current Ratio (Risk)
• Difficulty paying debts
• Weak financial safety
• Poor liquidity position
• Higher financial stress
🎯 Key Points to Remember
- Liquidity Ratios check a firm's short-term solvency and ability to pay immediate debts
- There are two types of Liquidity Ratios: Current Ratio and Quick Ratio
- Current Ratio = Current Assets ÷ Current Liabilities
- Current Liabilities = Total Liabilities - Shareholders' Funds - Non-Current Liabilities
- Current Assets = Total Assets - Non-Current Assets
- Working Capital = Current Assets - Current Liabilities
- The Ideal Current Ratio is 2:1, showing good financial health
- Higher Current Ratio generally means better liquidity and financial safety
❓ Frequently Asked Questions (FAQs)
We hope this presentation helped you understand Current Ratio clearly!
Remember, practice is key to mastering these concepts.
Keep solving numerical problems and you'll become an expert! 💪