Current ratio AO2, AO4
AO2 You need to be able to: Demonstrate application and analysis of knowledge and understanding Command Terms: These terms require students to use their knowledge and skills to break down ideas into simpler parts and to see how the parts relate: Analyse, Apply, Comment, Demonstrate, Distinguish, Explain, Interpret, Suggest
AO4 You need to be able to Demonstrate a variety of appropriate skills. Command Terms These terms require you to demonstrate the selection and use of subject-specific skills and techniques: Annotate, Calculate, Complete, Construct, Determine, Draw, Identify, Label, Plot, Prepare
The current ratio reflects the working capital position and indicates the ability of a business to pay its short-term creditors from the selling of its current assets, without having to resort to selling any of its fixed assets.
The current ratio is simply the ratio of all current assets to current liabilities. In other words:
Ideally the figure should always be greater than 1, which would indicate that there are sufficient assets available to pay liabilities, should the need arise. The general rule of thumb is that the figure should lie between 1.5 and 2.0. In other words, for every $1 of debts the firm will have between $1.50 and $2 in current assets to pay for this. The higher the figure the more liquid the business, but too high a figure may indicate that the firm is not investing sufficiently in higher earning assets.
In manufacturing it would be expected that the current ratio would fall between1.1 to 1.5. Generally where credit terms and large stocks are normal to the business, the current ratio will be higher than, for example, a retail business where cash sales and high stock turnover are the norm.
A problem with the current ratio is that it includes stock, which may include slow moving or redundant stock that is not liquid at all. Accepting that stock is a liquid asset assumes:
- That a buyer is available. If the product is out of date then perhaps nobody else wants them.
- The firm will get a fair price for them. This is unlikely, especially once the word gets around that the firm needs cash quickly.
- Any buyer will pay cash at once for the materials. A credit sale is of no use.
At best the firm can expect only a very poor return. It is best to ignore stocks when looking at liquidity and calculating ratios - hence use the acid test ratio as the key liquidity ratio. When comparing the acid test and current ratios, be sure to make it clear what the limitations of the current ratio are and explain the differences between them.