I often say that a current ratio can be too high and that a high ratio tends to indicate poor working capital management.
It’s interesting to see a local case that underlines my view. The directors of Rex Trueform, the Cape-based clothing retailer (it owns Queenspark), was taken to task by shareholders at one of its AGMs a short while ago because its financial results showed that while its operating performance was quite good with R44m in operating profit, it had R150m in cash on the balance sheet and not very much debt. This resulted in a current ratio of 5.6 and a quick ratio in excess of 4.
The points that the shareholders made were that the ratios are far higher than its competitors in the industry and that holding so much cash was not the optimal use of its capital.
The directors’ response to the challenge from shareholders was that, given the current difficult retail trading conditions, they wanted to stay liquid and hold cash (which many would say is a fair enough point of view). The problem for the shareholders, though, is that the returns on cash are too low at present and don’t meet the levels that shareholders expect. They want to see the cash (or at least a large chunk of it) put to better use, i.e. invested in future growth and expansion.
Lenders to this company are probably not very concerned with the situation as the risk of its failure is very low because of all the cash on hand. The problem for the company will come when it wants to raise additional capital for expansion when the economic recovery eventually does come. At that time, potential investors will point to the low returns that have been generated right now and decide not to go with it any further. So the directors’ short-term conservatism may come back to haunt the business in the future and, in this case, those high current ratios were a indicator of problems to come.