The current ratio is very poplar liquidity ratio; it is used to determine the short term liquidity of the company means that enough current assets (Cash, prepaid Insurance, Cash equivalents, Account receivable and Inventory etc) are available with company to meet it short term liabilities obligations.
In other words current ratio determines the company ability to pay off its short term liabilities via available current assets. In theory, higher the current of the company better will be the liquidity position.
Current ratio figure is calculated after dividing the company current assets with current liabilities of the company.
Let’s assume company ABC balance sheet contains currents assets of 10,000 dollars and 5,000 dollars current liabilities.
Current Ratio = $ 10,000/$ 5000 = 2.0
The current ratio is a good tool to investigate company liquidity but sometimes it’s misleading. Higher current ratio is not necessarily mean better liquidity and lower current ratio is not necessarily bad liquidity. Current ratio focuses on amount of current assets and liabilities although the fact is that turning current assets to cash require time which varies company to company.
Let compare two companies’ current ratios.
|Company A||Company B|
|Current Assets||$ 6000||$ 3,000|
|Current Liabilities||$ 2000||$ 1,500|
|Working Capital||$ 4,000||$ 1,500|
From the example one can easily say that Company A is a winner in liquidity race on basis of more current assets and working capital but here are few things to notice which contradict the Company A winner statement. Let say, Company A and Company B have 30 days to pay their liabilities.
• Company A requires 8 months to collect account receivable whereas company B gets money back within a month.
• Company A inventory turnover is 2 times in a year on the other hand Company B inventory turnover is 12 times in a year.
The above mentioned cases clearly state that Company A cannot meet its liabilities obligation on time because current assets taking too much time to convert into cash. Despite of company B lower ratio it is the winner due to least time required to convert current assets into cash and pay liabilities within specified period of time.
Managers should use current ratio for liquidity analysis of the company but should consider the other attributes as discussed in this tutorial.