Current Ratio

The current ratio measures a firm’s ability to pay its short-term obligations (due within one year) using its short-term assets. It is the most widely used liquidity ratio.

Formula

Current Ratio = Current Assets : Current Liabilities

or

Current Ratio = Current Assets / Current Liabilities

The result is expressed as a pure ratio (e.g., 2 : 1).

What goes into Current Assets

Current assets are those that are expected to be converted into cash or used up within one year. They include:

• Current investments (marketable securities)
• Inventories (stock of raw materials, work-in-progress, and finished goods)
• Trade receivables (debtors and bills receivable)
• Cash and cash equivalents (cash in hand, cash at bank, short-term deposits)
• Short-term loans and advances
• Other current assets such as prepaid expenses, advance tax, and accrued income

What goes into Current Liabilities

Current liabilities are obligations that are due for payment within one year. They include:

• Short-term borrowings (e.g., bank overdraft, cash credit)
• Trade payables (creditors and bills payable)
• Other current liabilities (e.g., outstanding expenses, income received in advance)
• Short-term provisions (e.g., provision for tax, proposed dividend)

The textbook's worked examples for this topic now live in this chapter's Illustrations & practice tab, alongside their full solutions.

Significance and interpretation

The current ratio shows the degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a safety margin — a buffer against uncertainty in the realisation of current assets or in the flow of funds.

The ratio should be reasonable. It should be neither very high nor very low.

• A very high current ratio (say, above 3 : 1) implies heavy investment in current assets. This is not a good sign because it reflects under-utilisation or improper utilisation of resources. Funds that could have been invested profitably elsewhere are tied up in idle or low-return assets. …