Question

Discuss the importance of the current ratio.

Answer 1

It explains the relationship between current assets and current liabilities. It is calculated as: `"current ratio"="current assets"/"current liablities"`

Current assets are those assets that can be easily converted into cash within a short period of time, like cash in hand, cash at bank, marketable securities, debtors, stock, bills receivable, prepaid expenses. etc.

Current Liabilities are those liabilities that are to be repaid within a year, like bank overdraft, bills payable, Short-term creditors, provision for tax, outstanding expenses, etc.

Importance of Current Ratio:

It helps in assessing the firm’s ability to meet its current liabilities on time. The excess of current assets over current liabilities provides a sense of safety and security to the creditors. The ideal ratio of current assets over current liabilities is 2 : 1. It means that the firm has sufficient funds to meet its current liabilities. A higher ratio indicates poor investment policies of management, and a lower ratio indicates a shortage of working capital and a lack of liquidity.