Question

Financial statement analysis: current rate (currrent ratio) Instructions: 1. Read the situation presented below and participate in the forum by answering as requested. • The company ABX requested a credit line to finance the production operations of a new article. The bank denied the request because in its analysis of the financial statements the current rate was less than 2. 2. Answer the following question: • Why do you think the bank considered that the current rate of less than 2 was not adequate? What other factors could be considered when evaluating a current rate of less than 2 as adequate? 3. When preparing your answer, explain what a company's current rate measures and its importance for effective financial planning.

Answer 1

Current ratio may be defined as the relationship between current assets and current liabilities. This ratio, also known as working capital ratio, is a measure of general liquidity and is most widely used to make the analysis of a short-term financial position or liquidity of a firm. It is calculated by dividing the total of current assets by total of the current liabilities.

Current Ratio=Current Assets/Current Liabilities

The two basic components of this ratio are: current assets and current liabilities. Current assets include cash and those assets which can be easily converted into cash within a short period of time generally, one year, such as marketable securities, bills receivables, sundry debtors, inventories, work-in-progress, etc. Prepaid expenses should also be included in current assets because they represent payments made in advance which will not have to be paid in near future.

Current Liabilities are those obligations which are payable within a short period of generally one year and include outstanding expenses, bills payables, sundry creditors, accrued expenses, short-term advances, income-tax payable, dividend payable, etc. Bank overdraft should also generally be included in current liabilities because it represents short-term arrangement with the bank and is payable within a short period. But where bank overdraft is permanent or long-term arrangement with the bank, it should be excluded

A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current obligations in time as and when they become due. On the other hand, a relatively low current ratio represents that the liquidity position of the firm is not good and the firm shall not be able to pay its current liabilities in time without facing difficulties.

An increase in the current ratio represents improvement in the liquidity position of a firm while a decrease in the current ratio indicates that there has been a deterioration in the liquidity position of the firm. As a convention the minimum of ‘two to one ratio’ is referred to as a banker’s rule of thumb or arbitrary standard of liquidity for a firm.

A ratio equal or near to the rule of thumb of 2: 1 i.e., current assets double the current liabilities is considered to be satisfactory. The idea of having double the current assets as compared to current liabilities is to provide for delays and losses in the realization of current assets.

However, the rule of 2 : 1 should not be blindly followed while making interpretation of the ratio, because firms having less than 2 : 1 ratio may be having a better liquidity than even firms having more than 2 : 1 ratio. This is so because the current ratio measures only the quantity of current assets and not quality of current assets.

A high current ratio may not be favourable due to the following reasons:

(i) There may be slow moving stocks. The stocks will pile up due to poor sale.

(ii) The figures of debtors may go up because debt collection is not satisfactory.

(iii) The cash or bank balances may be lying idle because of insufficient investment opportunities.

Limitations of Current Ratio:

Current ratio is a general and quick measure of liquidity of a firm. It represents the ‘margin of safety’ or ‘cushion’ available to the creditors and other current liabilities. It is most widely used for making short-term analysis of the financial position or short-term solvency of a firm.

But one has to be careful while using current ratio as a measure of liquidity because it suffers from the following limitations:

(a) Crude Ratio:

It is a crude ratio because it measures only the quantity and not the quality of current assets.

(b) Window Dressing:

Valuation of current assets and window dressing is another problem of current ratio. Current assets and liabilities are manipulated in such a way that current ratio loses its significance.

Window dressing may be indulged in the following ways:

(a) Over-valuation of closing stock.

(b) Obsolete or worthless stocks are shown in the closing inventory at their costs instead of writing them off.

Limitations of Current Ratio:

Current ratio is a general and quick measure of liquidity of a firm. It represents the ‘margin of safety’ or ‘cushion’ available to the creditors and other current liabilities. It is most widely used for making short-term analysis of the financial position or short-term solvency of a firm.

But one has to be careful while using current ratio as a measure of liquidity because it suffers from the following limitations:

(a) Crude Ratio:

It is a crude ratio because it measures only the quantity and not the quality of current assets.

(b) Window Dressing:

Valuation of current assets and window dressing is another problem of current ratio. Current assets and liabilities are manipulated in such a way that current ratio loses its significance.

Window dressing may be indulged in the following ways:

(a) Over-valuation of closing stock.

(b) Obsolete or worthless stocks are shown in the closing inventory at their costs instead of writing them off.

(c) Recording in advance cash receipts applicable to the next year’s sales.

(d) Omission of a liability for merchandise included in inventory.

(e) Treating a short-term obligation as a long-term liability.

(f) Inadequate provision for bad and doubtful debts

(g) Inclusion in debtors advances payment for purchase of fixed assets.

Window dressing is done to show current ratio at a particular figure. It does not present the real financial position of the concern. The inferences drawn on such a ratio will be faulty and deceptive.

Importance of Current Ratio

The current ratio helps investors and creditors understand the liquidity of a company and how easily that company will be able to pay off its current liabilities. This ratio expresses a firm’s current debt in terms of current assets. So a current ratio of 4 would mean that the company has 4 times more current assets than current liabilities.

The current ratio also sheds light on the overall debt burden of the company. If a company is weighted down with a current debt, its cash flow will suffer.