Rationale

The current ratio of a firm measures its short-term solvency, that is, its ability to meet short-term obligations. As a measure of short-term/current financial liquidity, it indicates the rupees of current assets (cash balance and its source of cash) available for each rupee of current liability/obligation. payable. The bigger the current ratio, the larger is the amount of rupees available per rupee of current liability the more is the firms ability to meet current obligations and the greater is the safety of funds of short-term creditors. Thus, current ratio, in a way, is a measure of margin of safety to the creditors.

The need for safety margin arises from the inevitable unevenness in the flow of funds through the current assets and liabilities account. If the flows were absolutely smooth and uniform each day so that inflows exactly maturing obligations, the requirement of a safety margin would be, small. The fact that a firm can rarely count on such an even flow requires that the size of the current assets should be sufficiently larger than current liabilities so that the firm would be assured of being able to pay its current maturing debt as and when it becomes due. Moreover, the current liabilities can be settled only by making payments whereas the current assets available to liquidate them are subject to shrinkage for various reasons, such as bad debts, inventories becoming obsolete or unsaleable and occurrence of unexpected losses in marketable securities and so on. The current ratio measures the size of the short-term liquidity buffer. A satisfactory current ratio would enable a firm to meet its obligations even when the value of the current asset declines.

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