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Current Ratio and its Importance

CFO Services

From our blog: SUNDAY, DECEMBER 9, 2012


A business keeps a certain level of inventory so that it will not face a stock out situation.  Similarly it holds a minimum amount of cash and bank balances to meet day-to-day expenses.  It also extends credit to customers, resulting creation of sundry debtors or bills receivable.  All these are components of current assets.  These are called current assets since they are expected to be converted into cash or cash equivalent in a short period of time, less than a year.

The current assets are not totally financed or funded by the business's own resources.  The current assets are partly funded by suppliers by extending credit, short term borrowings, etc.  As is the case of current assets, the current liabilities are also short term in nature and are expected to be cleared by the business within a short time, in any case less than a year.

Current Ratio refers to comparison of current assets to current liabilities.  Since current liabilities have to be honored in time to maintain the reputation and creditworthiness, the organization should hold sufficient current assets to meet current liabilities.  The current ratio measures the adequacy of current assets vis-a-vis current liabilities. 

The ratio is obtained by dividing the total current assets by current liabilities.

A number of 2 is considered minimum according to general financial management standards.  However, in my experience, in India, and especially among small and medium companies, it is seldom 2.  The current ratio actually ranges between 1-2 and in a few cases the ratio falls even less than one.

Indian banks generally consider any number 1.25 as good.  Many banks expect it to be at least 1.17 to be considered as eligible for takeover of an account from another bank.

When it falls below one, the enterprise should induct long term funds to strengthen its current ratio.

Ace has helped many clients improve their current ratio and working capital position by arranging working capital term loans of long maturities.



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