The Current Ratio

Financial statements like the balance sheet may not contain much information about the performance of businesses and firms to its users, it is, therefore, necessary to use financial ratios to analyze the financial performance of a firm or a business. A financial ratio is a numerical or arithmetic comparison between two items in a financial statement, a good example of a financial ratio is the current ratio which compares firm’s current assets against the current liabilities, the formula for calculating the current ratio is

Current ratio = current asset / current liabilities.

The rule for the assets to liability ratio should be 2:1 or higher, a higher current ratio indicates that the company is doing well as it is able to pay off its debts and remain with enough assets to continue operating, while a lower current ratio where the liabilities are more than the assets means that the company is doing bad as it is not able to pay off its liabilities and this may lead to solvency (Tracy 2009).

Many firms may have the need to reclassify some of their long-term current investments which include cash in hand and stock among other currents assets which can be converted into cash within a period of one year with the advantage that they are easy to convert into cash. However, transactions for reclassification of long-term investment are made at a lower cost at the fair value on the day of transfer; this will have a negative effect on the current ratio as it reduces the current ratio resulting from the decline in the value of current assets that were compared with the value of current liabilities. Therefore, reclassification of current long term assets makes the true financial position of the firm weaker (Hanif & Hanif 2005).

A firm may find it ethical to reclassify its long-term asserts in the short term when the maturity of the current liabilities fall in a short-term period, this is because the current liabilities are economic obligations that must be paid off using the current assets or other current liabilities like short term loans, for example, when the current liability falls due in a period of one year or less as per the balance sheet date may force the firm to resort to reclassifying its long-term current asserts in the short-term (Pagach, Diamond & Norton 2006).

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