How to calculate the current ratio and why is it important | ApnaCourse

by | Nov 10, 2016 | Financial Management

 Manu

Conversation Between

Vinu

 1

 Manu and Vinu about
Current Ratio

 2
Manu Vinu! You are looking very angry. What happened?
Vinu Manu! I am sick of our Bankers! They denied working capital loan to our company by just quoting one ratio.
Manu What was that Vinu?
Vinu They said our current ratio is very low and so they are not interested in funding our company.
Manu Ohhh…..
Vinu How can they talk like that?

That too just by looking at single ratios?

Unfair!!!!

Manu Vinu! Don’t blame the bankers. They are just agents of public. If they are quoting a particular ratio as the main reason to deny the loan, then it sounds very serious. i.e., your company has to work on certain things very seriously now.
Vinu Our company has long years of experience and presence in the market. I don’t see any problem with our company.
Manu No Vinu! If Banker is not happy with your financial ratio, then your company should seriously work on it. Because, all most all the companies in the country or for that matter, in the world, works predominantly with Bankers funds. So, if a Banker is not satisfied with your financial ratios, then you have not equipped to the expectation of the major stake holder. This will affect the future direction of the company. You may not get timely fund and you may not be able to grow!!
Vinu I agree Manu!
Manu Moreover, bank funds are supposed to be the cheapest funds in view of its tax benefits. So you have to work on it.
Vinu Ok! Tell me where we should work on?
Manu First tell me that ratio, which bankers are not comfortable with.
Vinu It is our Current Ratio of 0.87.
Manu My Goddd…..I fully support that banker.
Vinu Why????
Manu You are in a Financial mess now. How can you expect a banker to support you at this stage?
Vinu Can you explain clearly?
Manu Vinu. Your current ratio is 0.87
Vinu Yes
Manu It is at its dangerous level. Do you know how current ratio is calculated?
Vinu Yes! Very simple

Current Ratio = Current Asset / Current Liability

Manu Yes! Calculation is very simple. But implications are very serious.
Vinu What’s wrong with our ratio?
Manu Your ratio is 0.87

 

It means,

-for every Re.1 of Current Liability (short term liabilities),

-you have Re.0.87 of Current Assets (short term resource)

Vinu What’s problem in that?
Manu It is the problem.

 

Your liability is Re.1 and for paying that liability you have only Re.0.87 with you.

 

On the face, you don’t have sufficient money to pay even Re.1 fully. You are short by Re.0.13. Then how you will be able to pay the banker in Crores.

 

This ratio says, you have borrowed more and you don’t have adequate cash resources to pay back.

 

This also would mean, some short term creditors are angry with you, because you don’t have adequate cash, and so they may file case against your company for non payment!

 

This may go even go up to liquidation of company through court order!

Vinu My Goddd…..…Is it so serious?

 

So do you mean to say, we should have current assets matching current liability?

Manu If you have current assets = current liability, your current ratio will be 1:1.

 

But still banker will not be happy

Vinu But why?
Manu Because, sometimes, certain current assets will not be available for paying of your liabilities immediately
Vinu Like?
Manu Like Inventory, delayed debtors, etc.
Vinu So?
Manu So, banker will be expecting you to have more current assets.

 

It means, you will have more resources to pay off your liabilities.

Vinu Ok!
Manu Only when you have more resources and less liabilities, your liquidity position is said to be comfortable!
Vinu Yes! Now I understand, why our current ratio is very low?

 

We purchased all most all our products on credit. So we had high level of Creditors. This had inflated the current liability.

 

Since we purchased everything on credit, we had surplus cash, which we have invested in fixed assets which will take some more time break even and come back to us through profits.

Manu Since you have converted your cash into fixed assets, your current asset level also have come down.

 

On one side, your current liabilities have gone up and on the other side, your current assets have come down.

 

Lower numerator and higher denominator has resulted in very low ratio for your company.

Vinu Yes Manu!
Manu It means, your company should be facing difficulty in making payments like salary, creditors, is it not?
Vinu Yes Manu L
Manu It is because, you have sourced lot of short funds (creditors) and in turn used them for long term purposes. You cash got locked in Fixed Assets which will not come back to you in short cycle.

 

But your creditors will start asking for payments.

 

So whatever cash realised will go to them and eventually it will affect even the salary payment.

Vinu True!
Manu These are the very common implications of lower current ratio which that banker had identified just looking at the number of 0.87.

If the ratio is less than 1.00, we can presume all the above.

Vinu So, how a current ratio should be?
Manu Current asset should be greater than current liabilities.

 

Theoretically, 2:1 is considered as ideal current ratio.

 

But Banker will be happy, if your current ratio is at least 1.33

Vinu What is that 1.33?
Manu It means, for

 

Every Re.1 of Current Liability, you should have Re.1.33 of Current Assets!

Vinu I understood that! But what’s special in that?
Manu You calculate the proportion of current liability to current assets at that level
Vinu Current liability – 1.00

 

Current assets – 1.33

 

Current liability (1/1.33) is 75% of Current Assets.

Manu Yes!

Exactly.

At current ratio of 1.33, you are funding 75% of current assets through current liability.

It automatically conveys something else.

Vinu Hmmm??

Remaining 25%?

Manu  

Yes!

It means remaining 25% is funded by ………..

Vinu By???
Manu What is known as ‘NETWORKING CAPITAL’
Vinu Yes.

 

Current Assets – Current Liability = Net Working Capital

Manu True!

 

So when your ratio is 1.33, it means, you are contributing 25% to your business through Net Working Capital and it is the least expectation of any banker.

 

i.e., Bankers are ready to fund 75% for Working Capital, provided Owner contributes at least 25% of funds and it is demonstrated through 1.33.

Vinu Great….and Thank you Manu!

 

I never thought Current ratio will convey so many things!

 

Thanks again.

Manu Welcome Vinu!
N Raja CA, A Practicing Chartered Accountant with tonnes of passion for teaching. He also holds a PGDBA – Finance from Symbiosis SCDL and a B.Com., from Loyola College, Chennai. Read More.

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