Significance of the current ratio – A company maintains some amount of inventory in order to avoid an out of stock scenario. Likewise, it keeps a small amount of cash and bank balances on hand to cover day-to-day expenditures. It also provides credit to consumers, leading to the formation of debtors or bills receivable. Many of these are examples of existing assets. These are known as current assets because they are supposed to be turned into cash or cash equivalents within a year.
The current assets really aren’t entirely or solely financed by the firm’s own capital. Suppliers contribute to the funding of current assets by lending credit, making short-term loans, and so on. Current liabilities and current assets, are short-term and are intended to be settled by the firm in a short period of time.
Must Read – Advantages and Disadvantages of Current Ratio
The term “current ratio” refers to the ratio of current assets to current liabilities. Because existing obligations must be fulfilled before the deadline in order to protect the firm’s credibility and creditworthiness, the firm must maintain enough current assets to cover its short term liabilities. The current ratio evaluates the sufficiency of current assets in relation to current liabilities.
The ratio is calculated by dividing current assets by current liabilities.
As per general financial management standards, a ratio of 2:1 is called the bare minimum. Nevertheless, in my observation, it is rarely 2 in India, particularly for small & medium-sized businesses. In fact, the current ratio varies between 1-2, and in several situations, it becomes even less than one.
In India, a ratio of 1.25:1 is considered fine. Many financial institutions require it to be at least 1.17 in order to be deemed liable for account takeover by another branch.
When it goes well below 1, the businesses must focus on long-term assets to boost its current ratio.