We look at the current ratio to tell us whether a business was able to settle its current liabilities from its current assets, usually stock (inventory), trade debtors (accounts receivable) and cash, at the balance sheet date. Even if you’re happy with the ratio, it’s important to take a look at what makes up the current assets total because current assets are not all equally liquid (i.e. easily convertible to cash). For example, let’s say that there are two similar businesses that each have current assets of 2m and current liabilities of 1m. Their current assets are structured as follows;
Trade debtors 200,000
Bank and cash 200,000
Trade debtors 500,000
Bank and cash 700,000
So, both businesses have a current ratio of 2 but Business 1 is heavily reliant on stock and, in most cases (but not in every case), it’s difficult to liquidate stock quickly to settle short-term liabilities.
Business 2 would appear to be in a stronger position as far as liquidity is concerned but there are still questions to be asked before we can have a good understanding of the ratio. We’ll deal with those questions a little later in this series of blog posts.
The point is this; you can’t simply look at the ratio (i.e. 2 in this case) and draw a conclusion – you have to look behind the numbers. Normally we would look at the current ratio in conjunction with the quick ratio which removes the stock figure from the current assets total but even that can be misleading. Next in this series on our blog, when a quick ratio of 1 could give you the wrong picture.