The current ratio is one of the most helpful liquidity ratios in financial analysis as it helps to gauge the liquidity position of the business. In simple words, it shows a company’s ability to convert its assets into cash to pay off its short-term liabilities. The article discusses the different advantages and disadvantages of the current ratio.
It is a ratio of a company’s current assets to its current liabilities. The current ratio is widely used by banks and financial institutions when sanctioning loans to companies, and therefore this is a vital ratio for any company. There are different ways of analyzing and improving the current ratio to portray a better liquidity position of a company.
Along with knowing how to analyze and improve the current ratio, it is important to know the advantages and disadvantages of using the current ratio.
Advantages of Current Ratio
- Current ratio helps in understanding how cash-rich a company is. It helps us gauge the short-term financial strength of a company. Higher the ratio, the more stable the company is. The lower the ratio, the greater the risk of liquidity associated with the company.
- The current ratio gives an idea of a company’s operating cycle. It helps in understanding how efficient the company is in selling off its products; that is, how quickly the company can convert its inventory or current assets into cash. Knowing this, a company can optimize its production. This enables the company to plan inventory storage mechanisms and optimize the overhead costs.
- The current ratio shows the management’s efficiency in meeting the creditor’s demands. It also gives an understanding of the company’s working capital management/requirement.
Disadvantages of Current Ratio
- Using this ratio on a standalone basis may not be sufficient to analyze the liquidity position of the company as it relies on the amount of current assets instead of the quality of the asset.
- The current ratio includes inventory in the calculation, which may lead to overestimating the liquidity position in many cases. In companies where higher inventory exists due to fewer sales or obsolete nature of the product, taking inventory under calculation may lead to displaying incorrect liquidity health of the company.
- In companies with seasonal sales, you may see a reduced current ratio in some months and an increased ratio in others.
- The impact on the current ratio may be due to a change in inventory valuation methodology by the company. Such will not be a case while using the quick ratio since it does not consider inventory at all.
- An equal increase or decrease in the current assets and current liabilities can change the ratio. Hence, an overdraft against inventory can cause the current ratio to change. Thus, it is very easy to manipulate the current ratio.
The current ratio is a very good indicator of the company’s liquidity position amid certain limitations, which one needs to keep in mind before using and interpreting the ratio. One can look to use an acid test ratio that does away with some limitations of the current ratio; however, any of these ratios should be used in comparison/conjunction with other measures to interpret the short-term solvency of the company.
Quiz on Advantages and Disadvantages of Current Ratio
This quiz will help you to take a quick test of what you have read here.