Current Ratio Formula
Current ratio tells about the liquidity position of the
entity. Current ration can be calculated by dividing current asset with current
liabilities of the organization.
Current
Ratio = Current Asset .
Current Liabilities
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Current Ratio Formula Example
Closing
Stock = 20,000
Closing
Debtor= 30,000
Cash
= 20,000
Closing
Creditor= 10,000
Calculate
Current Ration
Solution
Current asset
Closing
Stock = 20,000
Closing
Debtor= 30,000
Closing
Cash = 20,000
70,000
Current
Ratio = Current Asset
Current Liabilities
=70,000/10,000
=7:1
Above example shows that
current asset are seven times than current liability. Company has more than
sufficient liquidity (cash) for liability settlement.
Reasons for High Current Ratio
One of the primary reasons
for high current ratio is stock pile up or over manufacturing. Increase in
receivable due to relax credit policy may also be a major reason for high
current ratio. Early payment to creditors is also major reason for high current
ratio.
Reasons for Low Current Ratio
One of the main reasons
for low current ratio is high turnover of the stock or low stock maintaining
policy. Other reason is delayed payment to the creditors. Decline in sales
would also reduce the cash and receivable, and thus a key reason for low
current ratio.
Ideal Current Ratio
Current ratio must be at
least 1:1. Different industry requires different current ratio. Generally, it
is assumed that current ratio between 1.5- 3 is fair. It is important to
remember that neither too low nor too high ration (current ratio) is
recommended.
Disadvantages
of High Current Ratio
One of the main
disadvantages of high current ratio is unnecessary poor financial management
(funds are unnecessary tied up). High current ratio indicates that more funds
are resources are allocated than requirement.
Disadvantages of Low Current Ratio
Companies are required to
maintain minimum current ratio; otherwise, companies would not be able to
finance the operations. Funds must be available with companies to settle the
immediate liabilities.
Default or delayed payment
to creditor may negatively impact the goodwill of the company. Similarly
default or delayed payment to the financial institution may result in fines and
other legal complications for the companies.
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