Current Ratio

This is the most important liquidity ratio. It indicates the firm's ability to pay its current liabilities out of its current assets. It shows the firm's commitment to meet its short-term liabilities (current liabilities). This ratio indicates the extent of 'margin of safety' or 'cushion' available to the current creditors. It is calculated by dividing the current assets by current liabilities. The formula is:

Current assets are those assets which can be converted into cash within an accounting year. It includes cash, bank balance, short-term investments, bills receivable, sundry debtors, closing stock, prepaid expenses, short-term loans and advances. Current liabilities are the liabilities which are payable within an accounting year. It includes bank overdraft, bills payable, sundry creditors, outstanding expenses, provision for taxation, proposed dividends, accrued interest, advance payments, long-term debt maturing within a year.

Traditionally, a current ratio of 2:1 i.e., two rupees of current assets for every rupee of current liabilities has been considered adequate. This standard was based on the assumption that in case of bankruptcy or/and falling prices, the book value of current assets can shrink by one half and yet the current liabilities (dues and obligations) can be met in time. If the current assets is less than twice the current liabilities, then payment of current liability affects the day-to-day operations of the concern. In theory, the larger the current ratio, the greater is the protection available to short-term creditors. However, on the other hand, a higher ratio is an indicator of idle fund, inefficient use of fund and excessive dependence on long-term fund, which is costlier than the current liabilities.

Thus, this 2:1 measure cannot be accepted as applicable to all companies irrespective of the type of their business since other factors that affect the working capital (current asset minus current liabilities) are also to be considered. In general the shorter the operating cycle, the lower the current ratio; also the longer the operating cycle the higher the current ratio.

Also, in practice, a company with a high current ratio may not be necessarily in a position to meet its obligations, due to improper distribution of current assets. Hence, this ratio should be used in conjunction with other ratios to give a better picture of the current financial position.

Current Ratio of Tata Steel  for the years 2006-07 and 2005-06 is computed below:

The current ratio of Tata Steel has increased considerably from 1.11 in 2005-06 to 2.51 in 2006-07. This more than double increase in current ratio can be attributed to the increase in cash and bank balances. 

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