Common myths about current ratio

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: "Our company's current ratio is low because we sell for cash and buy on credit"

"Non-current items, such as dealer deposits, depress our current ratio"

"A high current ratio implies large obsolete inventory and irrecoverable debtors"

"Current ratio is low because of large CPLTD" (current portion of long term debt refers to the portion of long term debt that will mature within the next one year)

"A high current ratio, beyond a point, may not indicate superior liquidity"

Do these statements sound familiar? Are these true or are they common excuses to justify a low current ratio? In this article, there is an analysis of each of these statements to clarify the use and abuse of the current ratio. It becomes evident that few, if any, of these statements stand detailed scrutiny; the current ratio was and continues to be a strong indicator of the true state of a company's liquidity.

The current ratio: constitution and importance

A company's current ratio is an important - possibly the most important - indicator of its current and prospective liquidity position; it is therefore a critical component of credit assessment of companies in the manufacturing, trading and services sector. A low current ratio provides a valuable signal of present or impending liquidity problems, though strong financial flexibility to raise long-term funds at short notice mitigates these risks to an extent.

Let us understand the basic principles of what the current ratio is, and what it signifies.

The current ratio is the ratio of short-term assets to short term liabilities. Mathematically,

Current Ratio = (Inventories + Debtors + other current assets) /(Total short term debt + CPLTD + Total Current Liabilities + Provisions)

This ratio signifies, as of a given date (typically the fiscal year-end), the amount of current assets that will get converted to cash over the next one year, vis-à-vis the amount of liabilities that will mature over the next one year. If the assets (in the numerator) are larger than the liabilities (in the denominator), the company is likely to have adequate cash to meet its obligations, and therefore will probably not face liquidity problems. The reverse is implied if liabilities exceed assets in the ratio. This is why the current ratio is the parameter most commonly used by bankers and financial analysts to measure companies' liquidity position.