Question

Pick one financial ratio ( current ratio, quick ratio or cash ratio) and discuss its benefits and detriments.

Answer 1

Current Ratio -

Current Ratio is one of the most important financial ratio to be analysed and tracked by any company. Current Ratio gives a clear indication of liquidity position of the the company and tells the management if the company will be able to meet its current liabilities with its current assets. Current Liabilities are short term liabilities which are repayable within a period of one year and current assets are assets which are assumed to be converted to cash within a similar period of one year to meet those current liabilities.

Current Ratio = Current Assets / Current Liabilities

Current Assets =  Cash, Marketable securities , Inventory, Debtors, Prepaid expenses etc

Current Liabilities = Short-term debt, Accounts payable, Creditors , Accrued expenses, other short term obligations etc.

Benefits of current ratio -

1 It indicates the short term financial health and stability of the company. Higher the ratio, better and more stable a company is.

2. It indicates how good the operating cycle of the company and how quickly a company is able to convert its inventory into debtors and finally convert it into cash.

3 It indicates the efficiency of the management i.e. how efficiently the management is able to run the company.

Disadvantages -

1 The ratio is not helpful if analysed on a standalone basis. If it is anlaysed with other ratios like quick ratio, turnover ratio, profitability ratio etc, it gives a better picture

2. A higher level of raw materials and other inventory and debtors inflates the ratio and management may tend to believe that its short term position is good which may not be the case, if the inventory is not getting converted to debtors and finally to cash in normal operating cycle.

3. In cyclical business, the ratio may fluctuate from period to period and may not show true picture.

4. The ratio may also fluctuate if the company changes the basis of valuation of inventory.