Current Ratio Essay

2942 WordsMay 27, 201312 Pages
DEFINITION OF CURRENT RATIO: Current Ratio is the relationship between current assets and current liabilities. It is also known as “Working Capital Ratio”. It is used for the analysis of short term financial position of company, to test liquidity and also measures the ability of company to repay its short term debts. The current ratio gives idea about the efficiency of a company's operating cycle. Formula: Current Ratio: Current Ratio = Current Assets Current Liabilities Components: The two basic components of current ratio are : current assets and current liabilities. Current Assets: These are the assets which are expected to be converted into cash within normal operating cycle of the company, generally one year and includes marketable securities, bills receivables, sundry debtors, (excluding bad debts or provisions), inventories, work in progress, etc. Prepaid expenses should not be included in current ratio. Current assets are called current because they continuously flowing into and out of the business, and are essential for day-to-day operations. The composition of current assets varies in different companies. Companies having manufacturing business usually heavily invest in raw material, work in progress and finished goods. These inventories will sell on credit, which will generate trade debtors. While retailer heavily invest in finished goods inventories and sell on cash basis. Current liabilities: These are the obligations, which should be settled within the normal operating cycle, generally one year and include bills payable, sundry creditors, outstanding expenses, bank overdraft, income tax payable, dividend payable, etc. RULE OF THUMB: A general rule of thumb for the current ratio is 2 to 1 or 2:1.Instead industry average is better than this rule of thumb. Current Ratio for small companies is 2:1, which indicates safety level and

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