Current Ratio: An Important Liquidity Ratio

26 Dec 2020  Read 959 Views

One of the most common reasons why liquidity is important for a business is to make payments and to meet current and/or regular cash needs. Liquidity refers to the ability of a company to meet its current obligations as and when they become due. It is one of the most essential factors that are responsible for the smooth running of a business.

A liquidity ratio measures the short term solvency of any firm. One such liquidity ratio is the Current Ratio. The current ratio compares a company's current assets to its current liabilities.

So, let's understand the current ratio in detail.

What is the Current Ratio?

A Current Ratio is that liquidity ratio with which we can identify a company's ability to pay its short term obligations or those that are to be due within one year. It is the most common ratio that is widely used by financial analysts. 

A current ratio can tell us the short term financial position of a company. This ratio is also called the 'Working Capital Ratio'. It tells us the relationship between Current Assets and Current Liabilities.

Calculation of Current Ratio

The calculation of the current ratio involves comparing a company's current assets to its current liabilities. We can find the current assets and current liabilities of a company in its Balance Sheet

The formula for calculating a current ratio is as follows:

Current Ratio = Current Assets ÷ Current Liabilities

  • Current assets include cash and those assets which can be easily converted into cash in a short period of time or one year such as Short-term Investments, Debtors, B/R, Stock, Prepaid Expenses etc.
  • Current liabilities include those obligations that are payable within a period of one year such as Creditors, B/P, Taxes, Dividend payable etc.

The Ideal Level: The ideal Current Ratio is considered to be 2:1. This ratio can be considered as safe and conservative because even if the current assets get reduced to half, then also the company will be able to clear off its short term debts and liabilities.

While calculating the current ratio of a company, we must compare it with the current ratio of its peer companies or companies that are involved in the same line of business.

A current ratio that is in average to the industry or slightly higher is considered to be good and eligible for further analysis. A current ratio that is lower than the industry average makes it non-acceptable and indicates risk. A very high current ratio indicates that a company is unable to utilize its assets efficiently.

How to Use a Current Ratio

Let us see how to use the current ratio while analyzing a company for investment. 

Assume that A, B, and C are three companies that are in the same kind of business and are competitors. By reading the Balance Sheet of all the three companies, we get the following information:

Company

Current Assets

Current Liabilities

Current Ratio

A

125 crores

100 crores

1.25

B

25 crores

30 crores

0.83

C

30 crores

31 crores

0.96

Now looking at this table, we find that company A has a current ratio of 1.25 which means that for every 1 rupee of debt (short term), company A has 1.25 rupees of assets to clear its obligations. 

Similarly, company B has 0.83 rupee of assets to clear its debt of 1 rupee and company C has 0.96 rupee of assets to clear its debt for 1 rupee. Thus, company A has enough assets which can be converted into cash to meet its short term obligations.

                                                  

A Case Study on Reliance Industries

The data below is obtained from the Balance Sheet of the company for the financial year ended in March 2020:

        Particulars

    Amount in Crores

Current Assets

 

Short Term Investments

72,915

Inventories

73,903

Sundry Debtors

19,656

Cash & Bank

30,920

Others

60,866

Total Current Assets

2,58,260 crores

Current Liabilities

 

Short Term Borrowings

93,786

Short Term Trade Pay

96,799

Other S.T. Liabilities

2,20,441

Short Term Provisions

1,890

Total Current Liabilities

4,12,916 Crores

According to the formula of the Current Ratio, we have:

Current Ratio = 2,58,260 ÷ 4,12,916

                         = 0.62 

As we can see that the current ratio of Reliance Industries was 0.62. It shows that there were not enough current assets in this company to clear off its short term debts.

But it does not completely mean that it is not worth investing. There are several other parameters that can indicate whether the company is good to invest in or not.

As a matter of fact, it was also seen that Reliance Industries got many large Institutional Investors for their company, e.g., Facebook, Silver Lake etc.

All these investments in Reliance Industries helped to clear its debt. And now, Reliance is on the verge of becoming a debt-free company. Moreover, during March, its P/E ratio was 18, which tells us that at that time, it was undervalued and was a good option for investment.                                             

*Note: This is not a recommendation either to buy or sell. It is for educational purposes only.

Importance of Current Ratio

This ratio is used by creditors to evaluate whether a company can be offered short term debts.

It also provides information about the company's operating cycle.

It shows a company's ability to convert its assets into cash to pay off its short-term liabilities.

Limitations of Current Ratio

While using the current ratio for analyzing a company for investment purposes, the following limitations must be kept in mind:

  • The current ratio only tells us the quantity of assets and not the quality of assets.
  • A current ratio can be easily manipulated by overvaluing the current assets.
  • A current ratio is incapable of telling whether a company is receiving timely payment from its customers or not. For example, a company can have a very high current ratio, but its customers are delaying payments. A current ratio does not give this type of information.
  • Several liabilities can also be neglected for just representing a good current ratio. 

Conclusion

As important as the current ratio is for analyzing a company's financial health, one should not make a solid assumption about its investment worth. A company with a current ratio of 2 or above does not always mean that it is a good company to invest in.

Moreover, it is not necessary that a current ratio always represents a company's complete liquidity or solvency. There are certain other factors also that are equally important while analyzing a company. When analyzing a company for an investment opportunity, we must give more priority to the quality of assets than the quantity of assets.

In the end, it is important to keep in mind that no single financial figure or ratio can be the sole parameter of defining its financial health and investment worth. Such decisions must be taken, keeping in mind all possible factors and looking at the company from all different angles. Only then, can the investment be utilized to its fullest potential.

About the Author: Gautam Raj | 2 Post(s)

Gautam possess a passion about writing on finance and stock market. He has done BA from Bilaspur University and is looking forward to become a successful fundamental analyst. He loves reading news and updates about the stock market and world economies, and thus, he is an expert in detailed oriented writing.

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