When you wish to evaluate a company’s performance, the best method to use is ratio analysis. The ratio analysis uses financial statements such as the income statement and the statement of financial position.
One of the critical components of the financial ratio is the current ratio that measures the relationship between the current assets and current liability (Cate, 2008).
The current ratio can also be referred to as the working capital ratio. If a company wishes to know its liquidity, the proper ratio to use is the current ratio.
The primary purpose of the current ratio is to measure the short-term financial position of the company.
The formula for calculating the current ratio is; the current assets divided by the Current Liabilities (Cate, 2008). In this article, we are going to discuss the advantages and limitations of using the current ratio.
It is worth noting that the current ratio is the component of current assets and the current liability.
The current assets are composed of the company assets that are easily convertible into cash. The majority of the current assets are used in the company’s normal operation (Cate, 2008).
Examples of the current assets; inventory, the cash, and cash equivalent, account receivable. Likewise, the current liability is composed of the liability due in less than one fiscal year.
Example of the current liability includes; account payable, the current portion of long-term liability, Bank overdraft due in one year and deferred revenue.
In most cases, the current ratio is confused with the acid ratio since they are calculated using the same formula and indicate the company’s liquidity.
The main difference between the current ratio and acid ratio is the inclusion of the inventory in the current assets when calculating the current ratio.
Advantages of the Current Ratio
The current ratio has numerous advantages that make it superior compared to other liquidity ratios. The primary advantage of the current ratio is that the ratio helps measure the financial health of a company.
If a company record a current ratio of more than one, it indicates that the company is in good health in term of liquidity (“Financial Statement Analysis,” 2012).
If the management realizes they have less than 1 of the current ratios, they must make a swift decision to salvage the situation.
The current ratio has numerous advantages that make it superior compared to other liquidity ratios. The primary advantage of the current ratio is that the ratio helps measure the financial health of a company.
If a company record a current ratio of more than one, it indicates that the company is in good health in term of liquidity (“Financial Statement Analysis,” 2012).
If the management realizes they have less than 1 of the current ratios, they must make a swift decision to salvage the situation.
Similarly, the current ratio gives the efficiency of the firms operating cycle. The current ratio indicates the efficacy of the management to manage the operating assets.
If the ratio is adverse or below one, the company will develop a strategy to optimize the overhead in the company.
The last advantage of the current ratio is that the ratio indicates the ability of the management to honor the creditor’s obligations. The ratio acts as the litmus paper on how well the administration can manage the working capital (“Financial Statement Analysis,” 2012).
Limitation of the Current Ratio
Although the current ratio has numerous pros, it also has several limitations. The primary disadvantage of the current ratio is that the ratio is not a sufficient indicator of the company’s liquidity.
The company cannot solely rely on the current ratio since it gives little information about its working capital.
The other limitation of the current ratio is the inclusion of the inventory in the calculation of the current assets. The inventory sometimes may take more than one to be converted into cash or revenue to the firm.
If the company has a high level of stock, it will indicate that the company is in an excellent liquidity position, but in a real sense, the company is in severe financial health (“Financial Statement Analysis,” 2012).
Lastly, the company may have an inconsistent current ratio if the sales are seasonal. If the sales are low, the company will record the lowest current ratio, but the current ratio will be high when the sales increase. The fluctuation of the current ratio will lead to a misconception of the company liquidity
