Question

The current ratio looks at the current liabilities versus current assets. Why is this ratio important and why not look at total liabilities versus total assets? What is the current ratio telling us?

Answer 1

CURRENT RATIO:-

Current Ratio is the measure of a company's Current assets to Current Liabilities. This ratio is important because Current ratio measures the liquidity of the company and the ability of the company to pay its obligations as they come due. The company would always want to maintain a healthy current ratio so that it is able to meet its obligations as and when required.

Few examples of Current assets include Cash in hand, Cash at Bank, Short term investments, Inventory, Accounts Receivables, etc. Similarly, examples of Current Liabilities include Accounts Payable, Notes payables(less than 1 year), etc.

A Current Ratio greater than 1 indicates that the company has a higher level of Current assets versus Current Liabilities in its Financial statements. Similarly, a current ratio lesser than 1 indicates that the company has a lower level of Current assets versus its current liabilities.

It is not reasonable to look at the total liabilities versus total assets as the ratio would not give an idea of the company's short term ability to meet its obligations as they come due. For example :- A company might have a larger percentage of plant and machinery on its balance sheet but has lesser current assets than the current liabilities. In such a case, inspite of having a higher ratio of plant assets, the company would not be able to pay off its obligations as they come due. As such, it makes it reasonable to measure current assets as a ratio of current liabilities.

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