Current Ratio Essay

Current ratio may be defined as the relationship between Current assets and Current liabilities. This is, also known as a working capital ratio, because it is related to the working capital of the firm. The current ratio is an important and most commonly used ratio to measure the short-term financial strength or solvency of the firm. It is calculated by dividing the total of current assets by total of current liabilities.

Current ratio = Current Assets / Current Liabilities (Or) Current Assets : Current Liabilities

The two basic components of this ratio are: current assets and current liabilities. A relatively high current ratio is an indicator of the firm is liquid and as the ability to pay its current obligations

The term liquidity refers to the ability of a firm to pay its short term obligations as and when they become due. As asset is considered liquid if it can be converted into cash without loss of time or value. Cash is the most liquid asset. Other assets which are considered to be relatively liquid and included in the quick assets are accounts receivable (i.e., debtors and bills receivable), short-term investments,Stock or Inventory excluded because it is not easily and readily convertible into cash. Similarly, prepaid expenses, which cannot be converted into cash and be available to pay off current liabilities, should also exclude from liquid assets. The quick ratio can be calculated by dividing the total of the quick assets by total of current liabilities.

A firm with a debt-equity ratio of 2 or less exposes its creditors to relatively lesser risks. A firm with a high debt-equity ratio exposes its creditors to greater risk. A high debt-equity ratio which indicates that claims of outsiders (creditors) or greater than those of owners, may not be considered by the creditors because it gives lesser margin of safety for them at the time of liquidation of the firm. In the same way, a very low ratio is not considered satisfactory for the shareholders because it indicates that the firm has not been able to low-cost outsiders funds to magnify their earnings.

4. Return on Equity

In a real sense, ordinary shareholders are the real owners of the company. They assume the highest risk in the company. They are entitled to all the profits remaining after all outsider claims are met preference dividend paid. In view of this, the profitability of a firm should be assessed in terms of return to the equity shareholders.it is calculated by dividing profit after taxes and preference dividend by the equity capital.

Return on Equity Shareholders funds = PAT – Pref. Dividend / Equity Shareholders