Current Ratio or Working Capital Ratio – Definition, Explanation and Use:
The current or working capital ratio is determined by dividing the total current assets by the total of current liabilities. It is used to determine the business’ ability to honor its short term commitments with its current resources.
The ratio is normally expressed on “time” basis, i.e., it is expressed as “answer of the ratio: 1”.
Click on Analysis of Financial Statement of a Business to read the solved example of current ratio.
Analysis and Interpretation – Ideal Current Ratio:
There are many opinions as to what the ratio should or should not be. Some suggest a current ratio between 1.5 and 2 as standard, i.e., a company would be financially sound if its current ratio is within that range. However the fact is that there is no ideal current ratio as even a ratio lower than 1.1 may be perfect for a supermarket chain which has virtually no trade receivables and which immediately converts its inventory into cash. However a higher ratio is to be seen necessary for a manufacturing company which holds inventory for a longer period and then sells them on credit terms.
Too high current ratio may reveal that the company is not efficiently utilizing its current resources. The too high ratio may also affect company’s profitability performance.
The liquidity and profitability are usually conversely correlated. Higher liquidity usually reduce profitability and vice versa so a trade off needs to be struck between them.