Financial statements are used for calculation of various important ratios. These ratios are used to evaluate a company’s financial and operational strength. Different ratios may serve different purposes. One of the most important aspects of a company’s overall performance is its liquidity position. Liquidity position indicates a company’s ability to use its short term assets to pay its short term liabilities.

Liquidity position of a company is measured by calculating current ratio and quick ratio. Information for calculating current ratio is available in the balance sheet of the company. Balance sheet is one of the most important financial statements of a company. Therefore, it is important for an individual to have a basic understanding of the balance sheet and its various components. Balance sheet is prepared at the end of the year.

Balance sheet has two sides: assets and liabilities. Current ratio is calculated by using values of current assets and current liabilities. Formula for calculation of current ratio is mentioned below:

Current Ratio

Current Assets/Current Liabilities

Let Us Study The Common Components Of Current Assets

Cash In Hand/Bank

Cash in hand/bank indicates the amount of cash readily available with the company. Cash is the most liquid form of current asset as it can be used immediately to pay company’s liabilities.

Stock/Inventory

Inventory is another component of current assets. Inventory is commonly found in manufacturing organizations. Total value of inventory includes the closing value of finished goods and the value of inventory held in the form of raw material or work in progress.

Accounts Receivable/Debtors

Accounts Receivable indicates the total amount of money that is required to be collected from the customers. In case, a company sells goods on cash basis only, it will have zero accounts receivable. This is because money is collected by the company from the customers at the time of selling the goods only.

Demand Deposits/Short Term Investments

A company may invest some part of its cash in short term financial instruments for a period of less than one year. These investments are made to earn some extra income in the form of interest on excess amount of cash available with the company.

Prepaid Expenses/Expenses Paid In Advance

A company may pay certain expenses in advance. Such expenses are known as prepaid expenses because they belong to a future period. Sometimes such expenses may cover a period which may extend beyond the current accounting period.

Let Us Study The Common Components Of Current Liabilities

Accounts Payable/Creditors

Accounts Payable indicates the total amount of money that is required to be paid to the suppliers/vendors. In case, a company purchases goods on cash basis only, it will have zero accounts payable. This is because money is paid to the vendors/suppliers in respect of all the purchases made by the company at the time of purchasing the goods.

Also Read

Meaning Of Unaudited Financial Statements For A Business
Four Different Types Of Financial Statements

Outstanding Expenses

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Another common component of current liabilities is the amount of any expense that is still required to be paid by the company. Such expenses are known as outstanding expenses and are reported as current liabilities because such expenses are expected to be paid by the company within a short time frame.