The current ratio is an indicator of a company’s short term liquidity. It’s mainly used to get an idea whether or not a business firm has enough resources to pay its debts over the next 12 months.
In financial analysis, ratios are used as yardstick or a standard of comparison, so that the performance as well as position – liquidity or solvencyof a business entity may be determined in an accurate manner.
A company can improve its liquidity ratios by raising the value of its current assets. A low liquidity ratio means a business firm may have to struggle to pay it short-term obligations. The current ratio helps us ensure the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, it may be understood that, the more capable the company is of paying its short-term obligations.
The calculation of current ratio includes current assets and current liabilities. Current assets can be defined as being those that will be converted in to cash in twelve months period. They are: Cash, Receivables, inventories, marketable securities and prepayments.
Current liabilities are those that are to be settled in twelve months period. Current liabilities are: Accounts payable, unearned revenues and wages payable etc.
The formula for current ratio is: Current Assets / Current Liabilities. The current ratio is calculated by dividing current assets by current liabilities of a business entity. Current ratio is one of the most powerful and effective tool of financial analysis. It is used to measure the short term solvency of a business entity. A ratio of greater than one obtained through current ratio calculation indicates the business entity has more current assets than current liabilities. It is generally accepted that a current ratio of 2 to 1 or greater is satisfactory. It shows that the business entity has comparatively more current assets than current liabilities. Current ratio also helps us determine whether or not a company is able to meet creditor’s demands. In this way, a good current ratio implies that the company can meet the creditors demands successfully. However, the Current ratio below 1 does not indicate a good sign for the company, as it is assumed that a company has no assets to pay liabilities which might lead to go bankrupt.
As Stated above, the current ratio is used to evaluate the short term solvency of a business entity. In this way, the current ratio, having been calculated on the basis of current assets and current liabilities is regarded as a standard of comparison. If the resultant figure is 2 or more, it is a good indication that the short term solvency position of a business entity is satisfactory - which meets the standard of comparison. Furthermore, the current ratio indicates that in the worst case, even if the value of current assets becomes half, the business unit will be able to survive and meet its obligation successfully. Thus, a current ratio can be regarded as an effective tool to determine the margin of safety while showing the short-term solvency position of a business entity.
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