Current Ratio

Meaning

Current ratio is a financial ratio that measures a company’s ability to pay its short-term debts and obligations. It is calculated by dividing the company’s current assets by its current liabilities

Formula

.Current Assets / Current Liabilities

Current ratio is expressed as a pure ratio. Example 2:1 or 5:2, etc.

What are Current Assets

Current assets are assets that can be converted into cash within one year.

Current Assets = Current Investments + Inventories + Trade Receivables + Cash and Cash Equivalents

What are included in Current Assets

S NoSub HeadItemsBrief Explanation
1Current Investments (Short Term Investments)Held to be converted into cash within 12 months of date of purchase
These are classified into    
– Equity, Preference, Debentures, Bonds    
  – Mutual Funds, Government/Trust Securities, partnership firms     
– Partnership Firms    
 – Marketable securities
2InventoriesHeld for trade in the ordinary course of business and includes :
      – Raw Materials, Work in Progress, Finished Goods, Goods Purchased for resale
Excluded –
Stores and Spares, Loose Tools
3Trade ReceivablesAmount receivables against goods sold in the ordinary course of business
Bills Receivables
Sundry Debtors less prov Provision for Bad Debts will be deducted while calculating Sundry Debtors
4Cash and Cash EquivalentsBalances with Banks
Checks/Drafts in Hand
Cash in Hand
Others

Current Assets definition as per Companies Act, 2013

Current assets are those assets which fulfill any of the following criteria:

  • Within the company’s normal operating cycle** :
    • It is expected to be realized i.e. converted into cash or cash equivalents, or
    • it Is intended for sale or consumption
  • It is held primarily for the purpose of being traded or
  • It is expected to be realized within 12 months after the reporting date,i.e. balance sheet date or
  • It is cash and cash equivalent, unless
    • it is restricted from being exchanged or
    • used to settle a liability
      • It is expected to be settled in companies normal operating cycle**. for at least 12 months after the reporting date.

**Meaning of Operating Cycle : It is the time between acquiring a Current asset like inventory, debtors, etc. and its realization into cash and cash equivalent. Where normal operating cycle cannot be identified, it is assumed to be a period of 12 months.

What are Current Liabilities

Current liabilities are obligations that a company is required to pay within one year. They include debts and other financial obligations that are due in the short term.

Current Liabilities = Short Term Borrowings + Trade Payables + Other Current Liabilities + Short Term Provisions

What are included in Current Liabilities

S NoSub HeadItemsExplanation
1Short Term BorrowingsBank Overdraft
Cash Credit
Current maturities of long term debtPart of long term borrowings repayable within 12 months/operating cycle
Loans from other parties repayable within 12 months/operating cycle from date of loan. Example – Loans repayable on demand
Deposits
Other Loans and Advances
2Trade PayablesSundry Creditors
Bills Payable
3Other Current LiabilitiesInterest accrued but not dueInterest provided in books of accounts but not due for payment
Interest accrued and dueInterest provided in books of accounts and is alsodue for payment
Income received in advanceAdvance received by the company where sale is not yet made or service is not yet rendered
Unclaimed/Unpaid DividendDividends declared but not yet claimed by shareholder
Excess application money refundable with interest
Unpaid matured deposit with interest
Unpaid matured debentures with interest
Calls in Advance
Other PayablesAny other payable due to be paid within 12 months or within operating cycle
     – Outstanding Expenses/Expenses Payable
     – Provident Fund payable
     – ESI Payable
4Short Term ProvisionsProvision for Employee BenefitsProvision for Gratuity
Provision for Expenses
Provision for Tax
Other Provisions

Current Liabilities definition as per Companies Act, 2013

These are liabilities, which fulfill any of the following criteria:

  • It is expected to be settled, and companies normal operating cycle**; or
  • It is held primarily for the purpose of being traded; or
  • It is due to be settled within 12 months after the reporting date, i.e. balance sheet date; or
  • The company does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting date.

**Meaning of Operating Cycle : It is the time between acquiring a Current asset like inventory, debtors, etc. and its realization into cash and cash equivalent. Where normal operating cycle cannot be identified, it is assumed to be a period of 12 months.

Interpretation

The current ratio indicates the extent to which a company’s current assets are able to cover its current liabilities. A high current ratio may indicate that a company has a strong ability to pay its short-term debts and obligations, while a low current ratio may indicate that the company is struggling to meet its short-term financial obligations.

The ideal current ratio differs from industry to industry depending on the nature of business and the risk involved. However, generally accepted standard of current ratio is 2 : 1. That is, the current assets should be twice the current liabilities.

High current ratio usually means a better liquidity position. But very high current ratio may indicate poor management of funds. Example

  • Company may have high inventory piling up due to poor sales. The current ratio may become high but it is not good
  • Company may have high trade receivables due to poor debt collection. But a high current ratio may not indicate this poor management of collections
  • Company may have idle cash lying with it. Current ratio in this case also will be high but idle funds in the form of cash are not good as it does not earn anything

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