The Current Ratio is one of the Liquidity Ratios use to assess an entity’s liquidity position by using the relationship between Current Assets and Current Liabilities. In other words, it is the tool used to assess whether current assets could pay off current liability or not.
This ratio is intended to assess the liquidity problem and assess the usages of the entity’s working capital. The entity’s liquidity position might implicitly look healthy if the current ratio higher than one, and it is not healthy if its ratio is less than one.
The current ratio provides the clue to the users or readers whether or not the entity could go into trouble to pay off its current liabilities by using its available cash and other current assets into cash.
This ratio also helps management think about the next cash flow strategy to solve current liquidity problems. Probably, negotiation with the bank for overdraft or sit down with suppliers for delay some payments.
But, just because the ratio is less than one it does not mean the company is in trouble with its liquidity problems.
Current Ratio = Current Assets / Current liabilities
- Current Assets include cash and cash equivalence, account receivable, inventories, and other current assets. This ratio is different from the quick ratio as it includes inventories.
- Liabilities include Account Payable, Accrual, Interest Payable, and Other Current Liabilities. As you can see, all of these items are liquid assets and liabilities. That is why we said this ratio is to assess the liquidity of an entity.
The Disadvantage of Current Ratio:
There are some disadvantages of using the current ratio to measure the liquidity problem of the entity. Those disadvantages or limitation including:
- For example, the current ratio includes the inventories in its calculation. If the inventory balance at the end of the years is significantly different, there will be significant differences in the ratio. No matter you have enough cash to settle liabilities.
- Using different valuation methods result from different ending balance of inventories, and it subsequently affects the ratio. Therefore, it also affects how you interpret the current ratio of the company as well.
Let illustrate this with an example:
As per the example below, the current assets are included in the inventory amount of $200,000, and they are quite a large amount. The inventories are classed as current assets, but they might not easy to convert into cash.
Because to be able to convert the inventories into cash, the company needs to sell to customers and get the cashback. Sometimes, the sales are on credit, and the company still needs time to collect the cash.
The calculation of the current ratio also includes account receivables which might also difficult to convert into cash.
Account Receivable seems easy to convert into cash. Still, we have to look back into account receivable policy and its collection histories to conclude how sensible this ratio is over the current liabilities.
In reference to the above example, the Current Assets, include the Account Receivable.
Account Receivable is the current assets, but somehow, the company might not recover from customers or take a long time collecting them back from the customers.
Therefore, when interpreting the current ratio, these things need to be taking into account.
Example and Calculation of Current Ratio:
- Cash and Cash Equivalents: $30,000
- Account Receivable: $150,000
- Inventories: $200,000
- Others current Assets: $100,000
- Account Payable: $25,000
- Current Tax Payable: $140,000
- Accrual Expenses: $150,000
- Overdraft: $90,000
What is the Current Ratio of the above company?
So now is time for us to calculate the current ratio. And here is the information provided in the scenario:
- Total Current Assets: $480,000
- Total Current Liabilities: $405,000
Base on the information that we have above, here is the answer:
Current Ratio: 1.2 ($480,000/405,000)
Current Ratio Analyst:
The simple concept of the current ratio is that the company should have enough cash to cover its current liabilities.
If the ratio is over 1, the liquidity ratios analysis means the company is securely paying its current liabilities by using its current assets. And if the ratio is less than one, that means the company could be in trouble paying its debt on time to creditors.
Very simple right?
However, this ratio includes Account Receivables and Inventories in the calculation, which might not be possible to convert into cash immediately.
In this example, the current ratio position is quite good. It is over 1. It simply means the company could use its current assets to pay its current liabilities.
As mentioned above, there are many factors to consider when analyzing the Current Ratio of the company. First, this Ratio is calculated by including some Current Assets that might not be easy to get cash for paying Current Liabilities.
When assessing this ratio, it is important to assess the possibility that inventories could convert into sales or cash. Main factors include amount, nature, and the averages period that inventories could convert into sales or cash.
More importantly, inventories include raw materials and work in progress which takes another step to convert them into finished goods. Therefore, to convert inventories into sales, the company may take a bit long time.
Related: The Quick Ratio Analyst
The current ratio is just one of the liquidity ratios, and the effectiveness of using or interpret it is strongly recommended to combine with others for ratios like quick ratio or acid test ratio, working capital, account receivable turnover, and inventories turnover, as well as industry average and previous years.