The current ratio is one of the most useful 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 while sanctioning loans to the 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, more stable the company is. Lower the ratio, greater is 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 is the company able to 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.
- Current ratio shows the management’s efficiency in meeting the creditor’s demands. It also gives an understanding of working capital management/requirement of the company.
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.
- Current ratio includes inventory in the calculation, which may lead to overestimation of 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 where sales are seasonal; you may see a reduced current ratio in some months and increased ratio in the other.
- Impact on current ratio may be due to 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. Hence, it is very easy to manipulate current ratio.
The current ratio is a very good indicator of the liquidity position of the company 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.