Current Ratio Formula

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

 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.