The Current Ratio
One of the first ratios that a lender or supplier reviews when examining a company is its current ratio. The current ratio measures the short-term liquidity of a business; that is, it gives an indication of the ability of a business to pay its bills. A ratio of 2:1 is preferred, with a lower proportion indicating a reduced ability to pay in a timely manner. Since the ratio is current assets divided by current liabilities, the ratio essentially implies that current liabilities can be liquidated to pay for current liabilities.
To calculate the current ratio, divide the total of all current assets by the total of all current liabilities. The formula is:
The current ratio can yield misleading results under the following circumstances:
- Inventory component. When the current assets figure includes a large proportion of inventory assets, since these assets can be difficult to liquidate. This can be a particular problem if management is using aggressive accounting techniques to apply an unusually large amount of overhead costs to inventory, which further inflates the recorded amount of inventory.
- Paying from debt. When a company is drawing upon its line of credit to pay bills as they come due, which means that the cash balance is near zero. In this case, the current ratio could be fairly low, and yet the presence of a line of credit still allows the business to pay in a timely manner.
For example, a supplier wants to learn about the financial condition of Lowry Locomotion. The supplier calculates the current ratio of Lowry for the past three years:
|Year 1||Year 2||Year 3|
The sudden rise in current assets over the past two years indicates that Lowry has undergone a rapid expansion of its operations. Of particular concern is the increase in accounts payable in Year 3, which indicates a rapidly deteriorating ability to pay suppliers. Based on this information, the supplier elects to restrict the extension of credit to Lowry.