How to calculate the current ratio and why is it important | ApnaCourse
Manu and Vinu about
|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.|
|Vinu||How can they talk like that?
That too just by looking at single ratios?
|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.|
|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|
|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
-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
|Manu||Because, sometimes, certain current assets will not be available for paying of your liabilities immediately|
|Manu||Like Inventory, delayed debtors, etc.|
|Manu||So, banker will be expecting you to have more current assets.
It means, you will have more resources to pay off your liabilities.
|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.
|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.
|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.
At current ratio of 1.33, you are funding 75% of current assets through current liability.
It automatically conveys something else.
It means remaining 25% is funded by ………..
|Manu||What is known as ‘NETWORKING CAPITAL’|
Current Assets – Current Liability = Net Working Capital
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!