Current ratio (also called liquidity ratio) measures the monetary volume of current assets in relation to current liabilities. In simple words current ratio determines how much entity holds in the form of current assets for 1 unit current liability. For example a current ration of 2 indicates that entity’s reported current assets are twice the entity’s reported current liabilities.
Current ratio is calculated using the formula:
Current ratio = Current assets / Current liabilities
PakAccountants has published financial statements with following figures:
Current assets 180,000
Current liabilities 120,000
Current ratio = 180,000 / 120,000 = 1.50
Analysis and Interpretation
Higher the ratio means higher the amount of current assets available to meet short term obligations and thus higher the liquidity of the entity. However, high current ratio might be the result of excessive inventory (or obsolete inventory that should be written down) and receivables that might require provision for doubtful debts.
Lower current ratio may be indicative of the fact that entity will be dependent on external source of finance or utilizing cash flows from its operating activities directly. In both cases entity’s operating cash flows are getting affected. If entity relies on outside finance then profits will be burdened by interest cost (finance cost). If operating cash flows are applied to pay liabilities then again entity is effectively short on cash asset to pay dividends.
One major assumption in current ratio is that inventory and receivables are treated as liquid assets i.e. assets that are readily convertible into known amounts of cash which might not be the case in reality.
Emphasizing again, liquidity ratios measure entity’s situation at a particular date and for this purpose the year end figures are mostly used.
Consider the following information:
As you can see that current ratio has deteriorated over a period of 3 years. Reducing current ratio may indicate entity’s weakening cash situation. Current liabilities are unchanged but current assets are falling, if the trend continues then according to current ratio entity might face liquidity issues in the future and might have to arrange additional finance to pay short term obligations.
However, before reaching any conclusion it is advised that analyst must consider other ratios and industry average as well. For instance if industry average is 1 and entity had higher current ratio because of high level of inventory then reducing current ratio is actually an improvement.
In short, to make better interpretation current ratio figures should not be considered in isolation.