Financial Analysis 1: Current Ratio Analysis
1. Definition
Current ratio is a ratio of the firm’s total current assets to its total current liabilities.
Current ratio = Current assets / Current liabilities
Low current ratio indicates that a firm may not be able to pay its future bills on time, particularly if conditions change, causing a slowdown in cash collections.
High current ratio indicates that an excessive amount of current assets and management’s failure to utilize the firm’s resources properly.
2. General Rule
When current ratio is equal to 2:1, it is considered an acceptable for most firms. Of course, we need to analyze the firm’s past history and goals as well as the current ratios of similar companies.
3. Example A
On December 31, 2016, the balance sheet of Marshal company shows the total current assets of 1, 100, 000 and the total current liabilities of 400, 000. You are required to compute current ratio of the company.
Current ratio = Current assets / Current liabilities
= 1100000/400000
= 2.75
This means that the current ratio is 2.75, indicating that the company’s current assets are 2.75 times more than its current liabilities. Obviously, this condition is considered acceptable since 2.75 is higher than 2.
Current ratio is a useful test of the short-term-debt paying ability of any business. A ratio of 2:1 or higher is considered satisfactory for most of the companies but analyst should be very careful while interpreting it. Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio may not always be a green signal. It requires a deep analysis of the nature of individual current assets and current liabilities. A company with high current ratio may not always be able to pay its current liabilities as they become due if a large portion of its current assets consists of slow moving or obsolete inventories. On the other hand, a company with low current ratio mat be able to pay its current obligations as they become due if a large portion of its current assets consists of highly liquid assets i.e., cash, bank balance, marketable securities and fast moving inventories.
4. Example B
The following data has been extracted from the financial statements of two companies, company A and company B. Both company A and company B have the same current ratio i.e., 2:1. Do both the companies have equal ability to pay its short-term obligations?
Of course, the answer is no. Company B is likely to have difficulties in paying its short-term obligations because most of its current assets consist of inventory. Inventory is not quickly convertible into cash. The company A is likely to pay its current obligations as they become due because a large portion of its current assets consists of cash and accounts receivables. Accounts receivable are highly liquid and can be converted into cash quickly.
5. Example C
The TD company’s current ratio is 2.5:1 for the most recent period. If total current assets of the company are 7500000, what are total current liabilities?
Current ratio = Current assets / Current liabilities
2.5/1 = 7500000 / Current liabilities
Current liabilities = 3000000
6. Example D
If current ratio is 1.5 and total current liabilities are 500000, what are total current assets?
Current ratio = Current assets / Current liabilities
1.5 = Current assets / 500000
Current assets = 750000
7. Limitations
Current ratio suffers from a number of limitations as given below.
Different ratio in different parts of the year: Some businesses have different trading activities in different seasons. Such business may show low current ratio in come months of the year and high in others.
Change in inventory valuation method: To compare the ratio of two companies it is necessary that both the companies use same inventory valuation method. For example, comparing current ratio of two companies would be like comparing apples with oranges if one uses FIFO cost flow asumption and the other uses LIFO cost flow assumption for the valuation of inventories. The analyst would, therefore, not be able to compare the ratio of two companies even in the same industry.
Current ratio is a test of quantity, not quality: It is not an exact science to test liquidity of a company because the quality of each individual asset is not taken into account while computing this ratio.
Possibility of manipulation: Current ratio can be easily manipulated by equal increase or equal decreae in current assets and current liabilities. For example, if current assets of a company are 10000 and current liabilities are 5000, the current ratio would be 2:1 as computed below
Current ratio = Current assets / Current liabilities
=10000/5000
=2:1
If both current assets and current liabilities are reduced by 1000, the radio would be increased to
Current ratio = Current assets / Current liabilities
=(10000-1000)/(5000-1000)
=2.25:1
To reduce the effect of above limitations current ratio is usually used in conjunction with other ratios like inventory turnover ratio, quick ratio and etc. These ratios can test the quality of current assets and together with current ratio provide a better idea of solvency.
Reference
https://www.accountingformanagement.org/