Current Ratio
Current ratio expresses the precise relation between current assets and current liabilities. It is calculated by dividing current assets with current liabilities.
Current Ratio = Current assets/Current liabilities.
It indicates the availability of current assets in rupees for every one rupee of current liabilities. A high ratio means that the firm has more investment in current assets. While a low ratio indicates that the firm in question is unable to retire its current liabilities, In fact, a satisfactory current ratio for any given firm is difficult to judge. For most manufacturing undertakings, a ratio of 2 : 1 is traditionally considered a bench-mark of adequate liquidity. However, in some of the undertakings like public utilities and service firms, this standard ratio is not particularly useful as they carry no inventories for sale.
Current ratio is equally useful to both the outsiders and the management. To an outsider, it is a measure of the firm’s ability to meet its short-term claims. So far as the management is concerned, the ratio discloses the magnitude of the current assets that the firm carries in relation to its current liabilities. As regards the outsider, the larger the ratio, the more liquid is the firm. But, from the management point of view, a larger ratio indicates excess investment in less profit-generating assets. On the contrary, a low current ratio or downward trend in the ratio indicates the inefficient management of working capital.
Nevertheless, the current ratio is a crude and quick measure of the firm’s liquidity as it is only a test of the quantity and not the quality. The limitation of this ratio as an indicator of liquidity lies in the size of the inventory of the enterprise. If inventory forms a high proportion of current assets, the 2:1 ratio might not be adequate, as a meaningful measure of liquidity.
Quick or Acid-test Ratio
This ratio is also called liquid ratio or acid test ratio. Recognising that inventory might not be very liquid or slow moving, this ratio takes the quickly realisable assets and measures them against current liabilities. This is a more refined of somewhat conservative estimate of the firm’s liquidity, since it establishes a relation between quick or liquid assets and current liabilities. To be precise, a quick asset is one that can be converted into cash immediately or reasonably soon without loss of value, for instance, cash is the most liquid of all assets. The other assets which are considered to be relatively liquid and included in the quick category are accounts and bills receivable and marketable securities. Inventory and period expenses are considered to be less liquid. Inventories normally require some time for realising into cash. The quick ratio is, then, expressed as a relation between quick assets and current liabilities, as:
Quick Ratio = Quick assets/Current liabilities ;
or = Current assets __ Inventories/Current liabilities.
Conventionally, a quick ratio of 1 : 1 is considered to be a more satisfactory measure of liquidity position of an enterprise. In fact, this ratio does not entirely supplant the current ratio; rather, it partially supplements current ratio and when used in conjunction with it, tends to give a better picture of the firm’s ability to meet its claims out of short-term assets.
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