Current Ratio

Current ratio (called working capital ratio)

Traditionally in a manufacturing company a current ratio of 2:1 or above is considered healthy, however in current economic environment of E-business, a lower current ratio is acceptable.

The general principle is that the current ratio should be proportional to the operating cycle. Thus, a shorter operating cycle may justify a lower ratio.

A high current ratio means that the company is better positioned against uncertainty if it is not able to obtain additional assets (via sales) in the near future. But an overly high current ratio indicates that management may not be investing idle assets productively.

The quality of accounts receivable and merchandise inventory should be considered before evaluating the current ratio. A low receivables turnover (Net credit sales ÷ Average accounts receivable) and a low inventory turnover (COGS ÷ Average inventory) indicate a need for a higher current ratio

Limitations to use current ratio to assess liquidity

1. Because cash is the only acceptable means of payment, it is important to consider the composition of current assets and determine whether those listed as current assets can readily converted to cash. For example if prepaid expenses compose most of the current assets, the current ratio overstates the liquidity of the company, because most of prepaid expenses can’t be converted to cash to settle the liabilities.
2. Current ratio can’t predict or indicate patterns of future cash flows, because a significant amount of receivable from one customer could be uncollected or significantly delayed if the customer files for bankruptcy.