Liquidity Ratios
Current Ratio
Measures the ability of the business to pay its short-term debts using current assets.
One-hour paid trial · Same-day reply · from RM50/hr
Formula
Current Assets ÷ Current Liabilities
= 2 : 1
Expressed as a ratio, e.g. 2:1.
Why this ratio matters
The Current Ratio matters because it tells owners, creditors, and banks whether a business holds enough Current Assets to settle its Current Liabilities as they fall due, without selling non-current assets or taking on further debt. Creditors and suppliers use it to judge credit risk before extending short-term credit or loans, while owners rely on it to plan working capital and avoid a cash-flow crisis. The ratio also guides management decisions on stock levels, credit policy towards debtors, and whether short-term borrowings should be restructured into longer-term financing.
Worked calculation
Perniagaan Maju Jaya has current assets of RM60,000 (stock RM30,000, debtors RM24,000, bank RM6,000) and current liabilities of RM30,000 (creditors).
| Item | RM |
|---|---|
| Closing stock | 30,000 |
| Debtors | 24,000 |
| Bank | 6,000 |
| Current assets | 60,000 |
| Current liabilities (creditors) | 30,000 |
= RM60,000 ÷ RM30,000
= 2 : 1
Interpretation for Paper 2
- For every RM1 of short-term debt, the business has RM2 of current assets to pay it.
- A value around 2:1 is often considered comfortable, but it depends on the industry.
- Creditors and banks are likely to feel more confident extending credit or short-term loans to this business, as a 2:1 ratio suggests a low risk of default.
- This ratio should be compared with previous years' ratios to see whether the business's liquidity is improving or deteriorating, with the industry average used as a benchmark.
- A 2:1 position shows the business has sufficient working capital to finance day-to-day operations, such as purchasing stock and paying expenses, without cash-flow strain.
How to improve this ratio
- Speed up collection from debtors by tightening the credit period or offering cash discounts, and use the cash collected to settle part of the Current Liabilities such as creditors, so that Current Liabilities fall and the Current Ratio improves.
- Restructure part of the Current Liabilities (such as bank overdraft) into a long-term loan, reducing short-term repayment pressure and improving the Current Ratio.
- Control stock levels by avoiding over-purchasing and clearing slow-moving stock promptly, so that funds are not tied up and the business's liquidity improves.
Common student mistakes
- Students mistakenly include Non-Current Assets (such as vehicles or buildings) in the Current Assets figure, when only stock, debtors, cash and bank should be counted.
- Students forget to include bank overdraft as a Current Liability, even though it is repayable in the short term and must be included in the calculation.
- Students place the figures the wrong way round, dividing Current Liabilities by Current Assets instead of Current Assets by Current Liabilities, producing an inverted ratio that is then misinterpreted.
Limitations
- It does not consider how easily stock can be turned into cash.
- It shows the position on a single date only and can change quickly.
- The ratio does not reveal the quality of Current Assets. For example, debtors may include bad debts that will never be collected, yet they are still counted as an asset.
- A business can 'window-dress' its financial statements near the year-end, such as repaying a short-term loan or bank overdraft with cash just before the balance sheet date and then re-borrowing shortly afterwards, to make the Current Ratio appear better than the business's real position.