Chapter 2, Problem 13Q

How is the current ratio computed and interpreted?

To determine

Discuss the manner in which the current ratio is computed and interpreted.

Explanation of Solution

Current ratio:

Current ratio is one type of liquidity ratios, it link between current assets and current liabilities. Thumb rule for current ratio is 2:1. The current assets are cash, marketable securities, accounts receivable, merchandise inventory prepaid expenses and so on. Current liabilities are accounts payable, short term notes payable, short term bonds and so on.

Current ratio is computed by dividing total current assets by total current liabilities. It calculates the capacity of the company to pay its short-term obligations with current assets. The current ratio is more than 1:1 the company has sufficient current assets to pay short-term obligations. The current ratio is less than 1:1; the company has not sufficient current assets to pay its short-term obligations. The current ratio is more than 2:1; it indicates the company having an excess amount of current assets after paying the short-term obligations.