What is the Current Ratio? Advantages and disadvantages of Current Ratio – Explained

Definition

The current ratio measures the ability of the business to pay off short-term obligations falling due in the next twelve months. Calculation and analysis of the current ratio help to assess the liquidity of the business and offers great help in understanding if the business is liquid and able to meet the commitments in near future.

Detailed understanding of the concept

The current ratio is calculated by comparing the current assets of the business with current liability. If the answer to this comparison is more than one, it indicates that the amount of the current assets in the business is more than the current liability. Hence, the business is considered to be liquid.

On the other hand, if the amount of the current assets is less than the current liability, the business is not perceived to be liquid. So, the business should consider enhancing the current assets, which can be done via raising long-term finance or equity.

It’s important to note that raising short-term finance does not seem to impact the current ratio as current assets and current liability increase in the same proportion. Instead, raising finance seems to impact the business profitability.

Further, this ratio helps to analyze the ability of the business to pay off their bills and other liabilities that fall due in a short time. Similarly, the business lenders seek to understand if the business has sufficient liquid funds and can pay off their interest on a timely basis.

So, this analysis helps them to understand if they should be lending an amount to the business—similarly, potential shareholders assess the ability of the business to pay a dividend with this matric.

Another main user of the business’s current ratio is a creditor that wants to assess the ability of the business to collect its dues.

Formula to calculate the current ratio

We can calculate the current ratio by using the formula below:

Current ratio = Current Assets / Current Liability

Current assets

Current assets are the assets owned by the business with maturity in less than twelve months. These assets include inventory, accounts receivables, marketable securities, short-term investments, cash, and cash equivalents, etc.

Current liability

A current liability is an obligation to pay off economic benefits in the next twelve months. It includes trade payable, bonds payable, short-term loans, and other short-term liabilities.

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Benchmark of the current ratio

A business with a current ratio of more than one is considered to be liquid; the reason is that it’s considered to have sufficient current assets for paying the current liability. On the other hand, a business with a current ratio of less than one is not desirable.

However, a very high value of the current ratio can is not desirable as well. The reason is that it may indicate the business management is not competent to use current assets efficiently. Further, a higher amount of cash and cash equivalent may also indicate the business cannot find some return generating opportunities.  

It’s equally important to note that desirable current ratios differ from business to business; some sectors are expected to have higher current ratios than others. Even some business current ratio below one is perfect. For instance, the business with the ability to sell the inventory and collect the cash before the date of paying suppliers and other lenders, etc., does not need to worry about the current ratio of less than one.

Further, the value of current assets is expected to increase when sold; the reason is that inventory is recorded at cost in the balance sheet and sold by adding a certain markup/margin. So, inventory sold and converted into cash is expected to increase current assets and increase the current ratio. Hence, a current ratio below one can be justified depending on the circumstances and analyzing the facts like profitability and ability if the business to collect cash, etc.

Sometimes, there may be some one-off obligations in the current liability that might impair the current ratio. So, we need to deeply analyze facts and figures of current assets and the current liability before forming an opinion regarding the business’s liquidity.

Advantages of using current ratio in financial analysis

Following are some of the advantages of the current ratio in financial analysis.

  • It helps to understand and plan for the short-term cash position of the business. For instance, the forecasted financial statement of the business might indicate significant profitability but the problem with the liquidity in the short term. So, the management of the business can decide to offer certain cash discounts and increase cash position. (Although there is some compromise on the profitability but leading to increasing the current assets and ultimate collection due to cash discount).
  • It helps to understand how efficiently the business manages working capital. So, cash flow can be better planned.
  • It gives a strong idea about the business’s operating cycle and helps to understand the gaps in cash availability and payment.
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Disadvantages of the current using ratio in financial analysis

Following are some of the disadvantages of the current ratio in financial analysis.

  • It provides limited information about the business’s liquidity position, and hence, liquidity position cannot be determined based on the current ratio only. Further, it provides limited information about working capital management. so, the business cannot depend on the current ratio for making a decision.
  • The current ratio calculation assumes that inventory is a current asset and can be sold within a year. However, that’s not true in all aspects. In simple words, a business may take more than a year to sell the inventory. The significant value of inventory in the current assets indicates that the business is highly liquid. Although, that might not be the case, and the business may be in trouble due to a decline in the sale of products and accumulating inventory. So, dependence on the current ratio may lead to impairment of overall financial analysis.
  • The value of the current ratio is dependent on the inventory, which is subject to seasonal variation. Hence, the current ratio may not be consistent in different accounting periods. So, there is little use for comparison, and standing analysis can lead to misconceptions.

To overcome the limitation of the current asset due to inventory, we need to calculate the quick ratio; the calculation of the quick ratio requires the removal of inventory from the current assets. So, it means that inventory is not considered a current asset to calculate the current ratio.

Conclusion

The current ratio compares the current assets of the business with current liability, and it helps to understand the business’s liquidity position. In simple words, the metric explains if the business will satisfy current/short-term obligations that fall due.

It’s a maturity analysis of the assets and liabilities and helps identify if there is some significant gap in the maturity. In such instances, the business needs to arrange finance or negotiate terms of payment with the suppliers. For instance, if current liabilities are higher and the business is facing scarcity of liquid resources, it may raise finance via debt financing. Although, it may lead to compromise on profitability and gearing status of the business.

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Potential lenders, investors, and suppliers use the current ratio to assess if the business can pay its dues on time and rely on the business to collect the funds.

If the business’s current ratio is more than one, it’s an indication of better liquidity as it means current assets are more than a current liability. On the other hand, if the current ratio is below one, it suggests problems with the liquidity, and the business needs to take certain actions.

This ratio is considered an essential part of financial analysis as liquidity assessment can manage working capital. However, a standalone analysis of the current ratio does not provide an in-depth understanding of liquidity and working capital management.

Frequently asked questions

Why do banks review the current ratio for approving a loan?

Banks are concerned about the collection of the interest and repayment of their loan. So, they review the current ratio to assess if the business has a sufficient liquidity position to pay off its dues on time.

What’s an ideal current ratio?

The current ratio equal to one is considered a threshold for the current assets and current liabilities. It’s better to have a current ratio above one, indicating a higher proportion of the current assets. However, the excess ratio may indicate low inventory turnover and create a question on the overall financial strength of the business.

Why are traditional retail stores expected to have a better current ratio?

Traditional stores hold and sell the inventory to the customer. That’s why these stores have significant inventory for sale to the customers. This leads to higher current assets and a higher value of the current ratio.

How is the current ratio linked with liquidity?

The good value of the current ratio indicates that the business has sufficient liquid resources and can meet short-term obligations falling due. On the other hand, the value of the current ratio lower than one indicates that the business has some liquidity problems.  

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