Current ratio (CR) is a company’s liquidity ratio that measures a business’ liquidity or ability to pay short-term and long-term obligations. It helps in understanding how cash-rich a company is, by comparing all of a company’s current assets to its current liabilities. Therefore, it answers the question: “How many dollars in current assets are there to cover each dollar in current liabilities?”
Current ratio is usually defined as assets that will be turned into cash in a year or less, and liabilities that will be paid in a year or less. Current assets include cash and cash equivalents, short-term investments, accounts receivable, prepaid expenses, inventory and other liquid assets; while current liabilities include short term/ current long-term debt, accounts payable, accrued expenses and other current liabilities.
The formula for calculating CR is as follows:
How Should You Interpret Your Company’s Liquidity Using Current Ratio
Current ratio shows how many times over the firm can pay its current debt obligations based on its most liquid assets. It also sheds light on the overall debt burden of the company. A ratio that is in line with the industry average or slightly higher is generally considered acceptable; whereas under 1 suggests that the company is weighted down with current debt and suffering from poor financial health. This implies that the liquidity position of the company is bad; it is unable to repay debts on time without facing difficulties.
In theory, a higher Current ratio is typically better with regard to maintaining liquidity; it means the greater capability to pay short-term obligations. Companies with larger amounts of current assets will more easily be able to pay off current liabilities when they become due.
However, more isn’t always better. 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. A high ratio exceeding 3 could indicate the company is not using its current assets efficiently, not effectively managing its working capital.
Limitations of Current Ratio
Not a single ratio to analyse company’s liquidity position
Current Ratio is just one part of liquidity ratio, and the effectiveness of it might be combing with others, for example, quick ratio, working capital, account receivable turn over, and inventories turn over. Using this ratio on a standalone basis may not be able to accurately analyse the liquidity position of the company as it relies on the amount (quantity) of current assets instead of the quality of the asset.
Comparing different companies
Businesses differ substantially between industries. Using different valuation methods result in different ending balance of inventories, which subsequently affect the ratio. Therefore, comparing the current ratios across companies of different industries may not be meaningful.
Overdraft against inventory
Current Ratio can be easily manipulated by the management. An equal increase in both current assets and current liabilities would decrease the ratio and likewise, an equal decrease in current assets and current liabilities would increase the ratio. Therefore, an overdraft against inventory can cause CR to change.
Improving Your Current Ratio To Support Your Business Growth
Current ratio relies on both current assets and current liabilities which essentially form the working capital. When current assets are lesser than the current liabilities, it forms a ratio of less than 1, which is not desirable. There is no fixed rule as to what the ratio should be kept at, though it may be wise to have it above 1. This is to ensure that the value of current assets is sufficient to cover short term obligations.
With Invoice financing, the fast and flexible cash flow solution will help companies unlock liquidity / cash flow tied up in the accounts receivable; which in turn positively increases the current assets figures in the balance sheet.
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