Question

Respond to the following in a minimum of 175 words: Imagine that you’ve been asked to explain 1 of the major accounting ratios to a group of high school students who have no background in business or accounting but are eager to learn. Using the term Current Ratio describe how you would explain it in your own words, using a specific example.

Answer 1

Current ratio is a liquidity ratio which measures a company's ability to pay its current liabilities with cash generated from its current assets. It equals current assets divided by current liabilities.

Current ratio is calculated using the following formula:

Current ratio=Current Asset / Current liability

Current Asset

Current assets contrast with long-term assets, which represent the assets that cannot be feasibly turned into cash in the space of a year. They generally include land, facilities, equipment, copyrights, and other illiquid investments.

Current assets are important to businesses because they can be used to fund day-to-day business operations and to pay for ongoing operating expenses. Since the term is reported as a dollar value of all the assets and resources that can be easily converted to cash in a short period, it also represents a company’s liquid assets.

However, care should be taken to include only the qualifying assets that are capable of being liquidated at the fair price over the next one-year period. For instance, there is a strong likelihood that many commonly used fast-moving consumer goods (FMCG) goods produced by a company can be easily sold over the next year. Inventory is included in the current assets, but it may be difficult to sell land or heavy machinery, so these are excluded from the current assets.

Current liability

Current liabilities are typically settled using current assets, which are assets that are used up within one year. Current assets include cash or accounts receivables, which is money owed by customers for sales. The ratio of current assets to current liabilities is an important one in determining a company's ongoing ability to pay its debts as they are due.

Let us understand what is current asset and current liabilities in simple words and let's do one example of current ratio.

Current asset=cash and other assets that are expected to be converted to cash within a year.(cash, cash equivalents, accounts receivable, stock inventory, marketable securities, pre-paid liabilities, and other liquid assets.)

Current liabilities=amounts due to be paid to creditors within twelve months.(accounts payables, short-term debt, accrued expenses, and dividends payable)

John stores sells Sports equipment to local hockey teams. John is applying for loans to help fund his dream of building an indoor court. John’s bank asks for his balance sheet so they can analysis his current debt levels. According to John’s balance sheet he reported $2,50,000 of current liabilities and $5,00,000 of current assets. John’s current ratio would be calculated like this:

Current ratio=Current Asset / Current liability

Current ratio=$5,00,000/$2,50,000=2