Current ratio (also known as working capital ratio) is a popular tool to evaluate short-term solvency position of a business. Short-term solvency refers to the ability of a business to pay its short-term obligations when they become due. Short term obligations (also known as current liabilities) are the liabilities payable within a short period of time, usually one year.
A higher current ratio indicates strong solvency position and is therefore considered better.
Current ratio is computed by dividing total current assets by total current liabilities of the business. This relationship can be expressed in the form of following formula or equation:
Above formula comprises of two components i.e., current assets and current liabilities. Both the components are available from the balance sheet of the company. Some examples of current assets and current liabilities are given below:
Examples of current assets:
- Marketable securities
- Accounts receivables / debtors
- Inventories / stock
- Prepaid expenses
Examples of current liabilities:
- Accounts payable / creditors
- Accrued payable
- Short term bonds payable
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. Your are required to compute current ratio of the company.
Current ratio = Current assets/Current liabilities
= 2.75 times
The current ratio is 2.75 which means the company’s currents assets are 2.75 times more than its current liabilities.
Significance and interpretation
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 may 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. Consider the following example to understand how the composition and nature of individual current assets can differentiate the liquidity position of two companies having same current ratio figure.
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 (2:1). Do both the companies have equal ability to pay its short-term obligations?
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 receivables are highly liquid and can be converted into cash quickly.
From this analysis, it is clear that the analyst should not only see the current ratio but also the composition of current assets.
Limitations of current ratio
Current ratio suffers from a number of limitations. Some are given below:
- Different ratio in different parts of the year:
Some businesses have different trading activities in different seasons. Such businesses may show low current ratio in some 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 assumption 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 decrease in current assets and current liabilities. For example, if current assets of a company are $10,000 and current liabilities are $5,000, the current ratio would be 2:1 as computed below:
$10,000 : $5,000
If both current assets and current liabilities are reduced by $1,000, the ratio would be increased to 2.25:1 as computed below:
$9,000 : $4,000
To reduce the effect of above limitations current ratio is usually used in conjunction with other ratios like inventory turnover ratio, debt to equity ratio and quick ratio etc. These ratios can test the quality of current assets and together with current ratio provide a better idea of solvency.