Accounts and finance

Table of Contents

1. Topic pack - Accounts and finance - introduction
2. 3.1 Sources of finance - notes
3. 3.1 Sources of finance - questions
4. 3.2 Investment appraisal - notes
5. Investment appraisal
6. 3.2 Investment appraisal - questions
7. 3.3 Working capital - notes
8. 3.3 Working capital - questions
9. 3.4 Budgeting - notes (HL only)
10. 3.4 Budgeting - questions
11. 3.5 Final accounts - notes
12. 3.5 Final accounts - questions
13. 3.5 Final accounts - simulations and activities
14. 3.6 Ratio analysis - notes
    1. Ratio analysis
    2. Profitability ratios
    3. Interpretation of profitability ratios
    4. Profitability - examples
    5. Liquidity ratios - introduction
    6. Current ratio
    7. Acid test ratio
    8. Efficiency ratios
    9. Efficiency ratios - ROCE
    10. Efficiency ratios - asset turnover ratio
    11. Efficiency ratios - stock turnover ratio
    12. Debtor days
    13. Creditor days
    14. Efficiency ratios - use and calculation
    15. Financial efficiency ratios - examples
    16. Shareholders' ratios
    17. Factors affecting share prices
    18. Gearing
    19. Ratio analysis - A summary
15. 3.6 Ratio analysis - questions
16. 3.6 Ratio analysis - simulations and activities
17. Printable version

Current ratio

One of the most universally known ratios, the current ratio reflects the working capital position and indicates the ability of a business to pay its short-term creditors from the realisation of its current assets, without having to resort to selling any of its fixed assets.

The current ratio is simply the ratio of all current assets to current liabilities. In other words:

Ideally the figure should always be greater than 1, which would indicate that there are sufficient assets available to pay liabilities, should the need arise. The general rule of thumb is that the figure should lie between 1.5 and 2.0. In other words, for every $1 of debts the firm will have between $1.50 and $2 in current assets to pay for this. The higher the figure the more liquid the business, but too high a figure may indicate that the firm is not investing sufficiently in higher earning assets.

In retail and manufacturing it would be expected that the current ratio would fall between1.1 to 1.5. Generally where credit terms and large stocks are normal to the business, the current ratio will be higher than, for example, a retail business where cash sales and high stock turnover are the norm.

The problem with the current ratio is that it includes stock, which may include slow moving or redundant stock that is not liquid at all. Accepting that stock is a liquid asset assumes:

• That a buyer is available. If the product is out of date then perhaps nobody else wants them.
• The firm will get a fair price for them. This is unlikely, especially once the word gets around that the firm needs cash quickly.
• Any buyer will pay cash at once for the materials. A credit sale is of no use.

At best the firm can expect only a very poor return. It is best to ignore stocks when looking at liquidity and calculating ratios - hence use the acid test ratio as the key liquidity ratio. When comparing the acid test and current ratios, be sure to make it clear what the limitations of the current ratio are and explain the differences between them.