current ratio
Today, I am going to talk to you about one of the short-term solvency ratios best known and that tend to be more used, that is, I am going to talk about the circulating ratio.
Also, in the article you will be able to learn to calculate it.
I hope you find it useful.
What are the short-term liquidity or solvency ratios according to authors?
According to Stephen A. Ross, Randolph W.
Westerfield, Jeffrey Jaffe, and Bradford D.
Jordan
In keeping with their name, short-term solvency ratios, as a group, are intended to provide information about a company’s liquidity, which is why they are sometimes called liquidity measures.
The main point of interest is the ability of the company to pay its bills in the short term without excessive pressure» (2021, p.
49).
Stephen A Ross
Definition according to Francisco Javier Calleja Bernal
«Speed with which current assets cánido be converted into money» (2017, p.59).
Francisco Javier Calleja Bernal
liquidity ratios
As perro be seen from the previous definitions, it perro be said that, through liquidity indicators (ratios), we are able to determine the capacity of a company to cover the obligations that it has in the short term.
In a few words, they help us to know the ease or difficulty that a company has to cover its short-term liabilities.
Therefore, the higher the ratio, the greater the chances of canceling (covering) short-term debts.
This helps us a lot because we cánido know how the liquidity of the company is.
Some of the most common liquidity ratios are as follows:
- Current or circulating reason.
- Quick reason or acid test.
- Working capital.
Of course, in today’s article I am going to focus solely on the current ratio.
What is a financial ratio?
First, the current ratio is a financial ratio that has been given a name.
Second, a financial reason is a reason.
Do you agree? Well, if you want to understand what a current ratio is, you first have to make sure that you understand what a ratio is.
What is a reason?
Simply put, a ratio is the result or quotient of a division and let me tell you, you’ve been using it since elementary school.
For example, imagine that you want to have a encuentro with 4 of your best friends.
Now, imagine that they get hungry and they order a single pizza.
If the pizza has 8 slices, How many slices does each person get?
The answer is 2, TRUE? How did you get to that result? You will most likely tell me that you divided 8 (slices) by 4 (people).
Well, the 2 is your result, quotient or your ratio.
How is it interpreted?
If we wanted to interpret the result obtained, we could say that each person will get 2 slices of pizza.
You see, you already knew how to interpret a reason, you just didn’t know you were doing it.
Now instead of pizza slices you have current assets and instead of people you have current liabilities.
If you wish, then I am going to leave you an article that I made especially about the reasons.
Maybe it will help you understand it better.
What is the current ratio?
Jonathan Berk, in his book, mentions that: “It is common for creditors to compare a company’s current assets with its current liabilities, in order to assess whether it has enough working capital to meet its short-term needs.”
As you perro see, the current ratio, being one of the liquidity ratios (short-term solvency), measures the ability of a company to meet its short-term obligations, that is, those that mature within one year.
Therefore, the current ratio helps us to know if a company has the resources to cover the payment commitments of the next 12 months.
The current ratio makes a relationship between the total current assets in front of total current liabilities.
As I already said, it indicates the financial health of a company and how it perro maximize the liquidity of its current assets to settle its debts and accounts payable.
Note: Do not forget that there perro be many financial reasons, but in the end, they are all reasons.
Therefore, the only thing that changes is the data that is taken to make the division (dividend and divisor).
In this case, current assets and current liabilities are taken into account.
Elabora to calculate the current ratio
More than a elabora, it is a ratio and since it is a ratio, we perro say that it is the result or quotient of a division.
In this case, the division considers the total current assets in front of total current liabilitiestherefore, it is as follows:
current assets
According to Bernal, current assets are money in any of its forms, as well as those properties of the entity to which one of these three situations will normally happen (in one year or less):
- We cánido convert it into money.
- They will be sold.
- They will be consumed.
Examples of Current Assets
- Cash (cash).
- Money deposited in the bank (banks).
- Investments in securities.
- Accounts receivable (customers and debtors)
- Aprecies receivable (promissory aprecies and bills of exchange)
- Goods.
- Advance payments.
current liabilities
Current liabilities cánido be understood as those obligations that a company has with a maturity of one year or less, counted from the cómputo sheet date.
It should be noted that some authors call it current, floating or enforceable.
Examples of Current Liabilities
- Accounts payable (suppliers and creditors).
- Documents payable (bills of exchange and promissory aprecies).
- Bank loans.
- Taxes to pay.
- Depósito certificates.
- advance charges.
How is the result of the current ratio interpreted?
I would really like you to go into the article that I recommended to you earlier, as it perro help you better understand what a ratio is and as a consequence, you will be able to better interpret financial ratios.
Now, I am going to give you an example and we are going to interpret the result.
Current Ratio Example
Since I gave the example of pizza, I’m going to use the same numbers.
Current assets are 8 and current liabilities are 4.
Well, the quotient is equal to 2.
Right? After all, we only have to divide 8 by 4.
So, we already have that the result is 2, but what does the 2 orinan?
The 2 represents the number of antecedent units (dividend) for each consequent unit (divisor).
If we return to the pizzas, we have that the antecedent is the slices of pizza and the consequent is the people.
Therefore, if we make the interpretation, we are left with 2 antecedent units (slices) for each consequent unit (person).
That is, for every 2 slices there is a person.
In other words, each person gets 2 slices.
Now we are going to do the same, but thinking about the following:
- Antecedent = current assets.
- Consequent = current liabilities.
So, for every 2 units of antecedent (current assets), there is 1 unit of consequent (current liabilities).
Let’s think about it in dollars:
For every $2 you have in current assets, you have $1 in current liabilities.
What does that orinan? Think about the following.
Imagine that you owe me $1 dollar and you have $2 dollars in your hands.
What’s happening? Well, you perro use $1 to pay me and you’ll still have $1 to use however you want.
After all, you have the money to fulfill your obligation to me, and you have money to spare.
Now you only have to play with the values you want, but you perro already give an interpretation to the values you obtain.
Why does the result of the current ratio have to be greater than 1?
You will be able to find in many places that the result you get in the current ratio must be greater than 1which means that you have enough resources.
Why is it so?
With what has been seen in the article, you already have enough bases to be able to give an answer.
Well, let’s play with the values.
Suppose the following:
- Current assets = 10.
- Current liabilities = 10.
The result of the division is 1, TRUE? Well, let’s interpret the result:
We have an antecedent unit (current assets) for each consequent unit (current liabilities).
So for every dollar we have in current assets, we have one dollar in current liabilities.
In other words, if you have a dollar, but you owe a dollar, how much do you have left? You have nothing left, but at least you were able to pay off your debt.
It is thanks to this that it is said that the current ratio must be greater than 1, since if it were less than 1, then you could no longer cover your short-term debt with your short-term assets.
What does it orinan that the result is less than 1 in current assets?
Well, I think I already gave you the answer before, but I recommend that you play with the values of current assets and current liabilities so that you perro practice your interpretation.
Of course, if the result is less than 1, then, therefore, it means that you do not have enough resources and measures must be taken to avoid problems when paying.
On the other hand, you have to understand that the greater the current assets with respect to the current liabilities, the company will have a greater possibility of encuentro its obligations in the short term.
Also, having good liquidity perro help you get loans (if necessary) to be able to finance yourself in the future.
Solved problems of current ratio
As I said before, it is a financial indicator that is used to evaluate the ability of a company to pay its obligations in the short term.
Next, I present some solved exercises of circulating ratio:
Current ratio exercise 1
Company XYZ has current assets of $200,000 and current liabilities of $100,000.
Calculate the current ratio.
Solution
- RC= Current assets / Current liabilities
- RC = $200,000 / $100,000
- CR = 2
Interpretation:
The current ratio of 2 indicates that Company XYZ has $2 in current assets for every $1 in current liabilities. This means that the company has enough liquidity to meet its short-term obligations.
Current ratio exercise 2
Company Antes de Cristohas current assets of $150,000 and current liabilities of $200,000.
Calculate the current ratio.
Solution of exercise 2
- RC= Current assets / Current liabilities
- RC = $150,000 / $200,000
- Current ratio = 0.75
Interpretation of exercise 2
The current ratio of 0.75 indicates that Firm Antes de Cristohas $0.75 in current assets for every $1 in current liabilities. This means that the company may find it difficult to meet its obligations in the short term.
Current ratio exercise 3
Company A and Company B have the following current assets and liabilities:
Company A:
- Current assets: $200,000
- Current liabilities: $50,000
Company B:
- Current assets: $300,000
- Current liabilities: $100,000
Which firm has a better current ratio?
Solution of exercise 3
First, the current ratio will be calculated for each company:
Company A:
- RC of company A = Current assets / Current liabilities
- = $200,000 / $50,000
- = 4
B-corporate:
- RC of company B = Current assets / Current liabilities
- = $300,000 / $100,000
- = 3
Interpretation of exercise 3
Company A has a current ratio of 4, which means that it has four times as many current assets as current liabilities.
On the other hand, Company B has a current ratio of 3, which means that it has three times as many current assets as current liabilities.
In general terms, a current ratio greater than 1 indicates that a company has enough current assets to cover its short-term obligations, while a current ratio less than 1 may be a sign that the company may have difficulty paying its debts at short term.
In this case, company A has a better current ratio than company B, indicating that it has a greater ability to pay its short-term debts.
This could be seen as a positive sign by investors and lenders.
Although, it is important to note that many more financial reasons have to be taken into account in order to give a more accurate diagnosis.
Exercise 4
Suppose a company has the following data for the year 2023:
- Inventory: $100,000
- Accounts Receivable: $50,000
- Accounts Payable: $25,000
To calculate the current ratio, we first need to calculate current assets and current liabilities.
Current assets include inventory and accounts receivable, while current liabilities include accounts payable.
current assets:
- Current assets = Beginning inventory + Accounts receivable
- Current assets = $100,000 + $50,000
- Current assets = $150,000
current liabilities:
- Current liabilities = Accounts payable
- current liabilities = $25,000
Now we perro calculate the current ratio:
- RC = Current assets / Current liabilities
- RC = $150,000 / $25,000
- Current ratio = 6
This means that for every dollar (peso) of current liabilities, the company has $6 of current assets.
A current ratio of 6 could be considered excellent since it indicates that the company has enough current assets to cover its current liabilities.
Although a high current ratio is generally considered a sign of solvency and liquidity, it perro also indicate that a company has an excessive amount of cash or inventory compared to its current liabilities.
This perro be a disadvantage as having too many current assets perro orinan that a company is missing out on profitable investment opportunities in other projects or long-term assets.
Bibliography
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