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Bank Promotion Exams |
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Current Ratio or Working Capital Ratio The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off its short-term liabilities with its current assets. The current ratio is an important measure of liquidity because short-term liabilities are due within the next year. This means that a company has a limited amount of time in order to raise the funds to pay for these liabilities. Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that companies with larger amounts of current assets will more easily be able to pay off current liabilities when they become due without having to sell off long-term, revenue generating assets. The current ratio is calculated by dividing current assets by current liabilities. The current ratio helps investors and creditors understand the liquidity of a company and how easily that company will be able to pay off its current liabilities. This ratio expresses a firm's current debt in terms of current assets. So a current ratio of 4 would mean that the company has 4 times more current assets than current liabilities. A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make current debt payments. Formula Current Ratio or Working Capital Ratio = Current Assets / Current Liabilities Example 1: XYZ shoes sells shoes. It is applying for loans to help fund to increase the inventory. The bank asks for its balance sheet so they can analysis the current debt levels. According to XYZ shoes's balance sheet it reported 10,00,000 of current liabilities and only 2,50,000 of current assets. Will the loan get approved? Current Ratio = Current Assets / Current Liabilities XYZ shoes only has enough current assets to pay off 25 percent of his current liabilities. This shows that XYZ shoes is highly leveraged and highly risky. Banks would prefer a current ratio of at least 1 or 2, so that all the current liabilities would be covered by the current assets. Since XYZ shoes's ratio is so low, it is unlikely that it will get approved for his loan. Example 2: Ms. Ankita Agency has several loans from banks for equipment they purchased in the last five years. All of these loans are coming due which is decreasing their working capital. At the end of the year, they had 1,00,000 of current assets and 1,25,000 of current liabilities. Find out its Working Capital Ratio. The working capital ratio is calculated by dividing current assets by current liabilities. Formula WC Ratio = CA/CL ................................. |