Current Ratio - Liquidity Ratio - Working Capital Ratio


Definition

Current ratio, also known as liquidity ratio and working capital ratio, shows the proportion of current assets of a business in relation to its current liabilities.

Formula

Current Ratio=Current Assets
Current Liabilities

Explanation

Current ratio expresses the extent to which the current liabilities of a business (i.e. liabilities due to be settled within 12 months) are covered by its current assets (i.e. assets expected to be realized within 12 months). A current ratio of 2 would mean that current assets are sufficient to cover for twice the amount of a company's short term liabilities.

Example

ABC PLC has the following assets and liabilities as at 31st December 2012:

$m$m
Non Current Assets
Goodwill75
Fixed Assets75150
Current Assets
Cash in hand25
Cash in bank50
Inventory25
Receivable100200
Current Liabilities
Trade payables100
Income tax payables60160
Non Current Liabilities
Bank Loan50
Deferred tax payable2575

Current ratio will be calculated as follows:

Current Ratio=Current Assets=200=1.25
Current Liabilities160

Interpretation & Analysis

Current ratio is a measure of liquidity of a company at a certain date. It must be analyzed in the context of the industry the company primarily relates to. The underlying trend of the ratio must also be monitored over a period of time.

Generally, companies would aim to maintain a current ratio of at least 1 to ensure that the value of their current assets cover at least the amount of their short term obligations. However, a current ratio of greater than 1 provides additional cushion against unforeseeable contingencies that may arise in the short term.

Businesses must analyze their working capital requirements and the level of risk they are willing to accept when determining the target current ratio for their organization. A current ratio that is higher than industry standards may suggest inefficient use of the resources tied up in working capital of the organization that may instead be put into more profitable uses elsewhere. Conversely, a current ratio that is lower than industry norms may be a risky strategy that could entail liquidity problems for the company.

Current ratio must be analyzed over a period of time. Increase in current ratio over a period of time may suggest improved liquidity of the company or a more conservative approach to working capital management. A decreasing trend in the current ratio may suggest a deteriorating liquidity position of the business or a leaner working capital cycle of the company through the adoption of more efficient management practices. Time period analyses of the current ratio must also consider seasonal fluctuations.

Industry standards

Current ratio must be analyzed in the context of the norms of a particular industry. What may be considered normal in one industry may not be considered likewise in another sector.

Traditional manufacturing industries require significant working capital investment in inventory, trade debtors, cash, etc, and therefore companies operating in such industries may reasonably be expected to have current ratios of 2 or more.

However, with the advent of just in time management techniques, modern manufacturing companies have managed to reduce the size of buffer inventory thereby leading to significant reduction in working capital investment and hence lower current ratios.

In some industries, current ratio of lower than 1 might also be considered acceptable. This is especially true of the retail sector which is dominated by giants such as Wal-Mart and Tesco. This primarily stems from the fact that such retailers are able to negotiate long credit periods with suppliers while offering little credit to customers leading to higher trade payables as compared with trade receivables. Such retailers are also able to keep their own inventory volumes to minimum through efficient supply chain management.

Current ratios of Wal-Mart Stores, Inc and Tesco PLC as per 2011 annual reports are 0.88 and 0.65 respectively.

Importance

Current ratio is the primary measure of a company's liquidity. Minimum levels of current ratio are often defined in loan covenants to protect the interest of the lenders in the event of deteriorating financial position of the borrowers. Financial regulations of various countries also impose restrictions on financial institutions to lend credit facilities to potential borrowers that have a current ratio which is lower than the defined limits.