LIQUIDITY-CURRENT RATIO: WHAT IS IT?
liquidity - A focus on the current ratio: it involves the liquid assets of a business and refers to the ability of a business to quickly convert its assets to cash. This also is known as "marketability."
The Formula for calculating the Current Ratio [also known as the Working Capital Ratio]:
WHY DOES THE CURRENT RATIO MATTER?
The current ratio is important because of this liquidity ratio (*) is used as an active indicator to measure the ability of a business to pay its short-term obligations (debts and payables). The larger the current ratio, the more capable the business is of paying its debts and payables, or the better the financial position of the business.
This ratio used to appraise the debt exposure represented on the balance sheet.
It is suggested that a current ratio of 2:1 is about right for most businesses (Helfert, 2001) because this proportion appears to permit a shrinkage of up to half in the value of current assets, while still providing enough cash to cover all current liabilities. In this case, for every $2 of current assets, there is $1 of current liability, and therefore the business is able to meet its short-term [less than 12 months] to cover all debts and payables.
Obviously as mentioned, the larger the Current Ratio, the better the position of the debt holders. Helfert (2001) advises that because a higher ratio would certainly appear to provide a comfortable support against drastic loses of value in the events of business failure, hence, a large excess of current assets over current liabilities is to help protect claims. Also, this should inventory have to be liquidated at a forced sale and accounts receivable involve sizable collection issues.
However, in viewing from another angle, it is warned that an excessively high current ratio might signal slack management practices because it could indicate idle cash balances and poor credit management that result in overextended accounts receivable (Helfert, 2001). Further, the issues of going concerns are crucial in business management. Helfert argues that the above common rule of 2:1 for the current ratio is the problem of not reflecting the top priority of management of going concerns. Therefore, according to Helfert, a lender or creditor looking for future business with a successful client should bear this in mind; they are advised to turn to the type of cash flow analysis to judge the viability of the business as a client.
Helfert, E., A. (2001). Techniques of Financial Analysis - A Guide to Value Creation. Irwin McGraw-Hill. Singapore
(*)
outlines three main types of Liquidity Ratios as below:- the Current Ratio,
-the Quick Ratio, and
-the Operating Cash Flow Ratio.
These Liquidity Ratios are used to measure the capacity of the business to meet short-term financial commitments as they become due [less than a year].
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