Current Ratio : An important Liquidity Ratio

One of the most common reasons why liquidity is important for a business is to make payments and to meet current and/or regular cash needs.

Liquidity refers to the ability of a company to meet its current obligations as and when they become due. It is one of the most essential factors responsible for a business's smooth running.

A liquidity ratio measures the short-term solvency of any firm. One such liquidity ratio is the Current Ratio. The current ratio compares a company's current assets to its current liabilities. So, let's understand the current ratio in detail.

What is the Current Ratio?

A Current Ratio is the liquidity ratio with which we can identify a company's ability to pay its short-term obligations or those that are to be due within one year. It is the most common ratio that financial analysts widely use. 

A current ratio can tell us the short-term financial position of a company. This ratio is also called the 'Working Capital Ratio'. It tells us the relationship between Current Assets and Current Liabilities.

Calculation of Current Ratio

Calculating the current ratio involves comparing a company's current assets to its current liabilities. We can find a company's current assets and current liabilities on its Balance Sheet. The formula for calculating a current ratio is as follows:

Current Ratio = Current Assets ÷ Current Liabilities

• Current assets include cash and those assets which can be easily converted into cash in a short period of time or one year, such as Short-term Investments, Debtors, B/R, Stock, Prepaid Expenses etc.
   
• Current liabilities include obligations payable within one year, such as Creditors, B/P, Taxes, Dividends payable, etc.

The Ideal Level: The ideal Current Ratio is considered to be 2:1. This ratio can be considered safe and conservative because even if the current assets get reduced to half, the company will also be able to clear off its short-term debts and liabilities.

While calculating a company's current ratio, we must compare it with the current ratio of its peer companies or companies involved in the same line of business.

A current ratio that is on average to the industry or slightly higher is considered to be good and eligible for further analysis. A current ratio that is lower than the industry average makes it non-acceptable and indicates risk. A very high current ratio indicates that a company cannot utilize its assets efficiently.

How to use a Current Ratio

Let us see how to use the current ratio while analyzing a company for investment. Assume that A, B, and C are three companies with the same kind of business as our competitors. By reading the Balance Sheet of all the three companies, we get the following information:

Now looking at this table, we find that company A has a current ratio of 1.25, meaning that for every 1 rupee of debt (short term), company A has 1.25 rupees of assets to clear its obligations. 

Similarly, company B has 0.83 rupees of assets to clear its debt of 1 rupee and company C has 0.96 rupees of assets to clear its debt of 1 rupee. Thus, company A has enough assets which can be converted into cash to meet its short-term obligations.

A case study on Reliance Industries

The data below is obtained from the Balance Sheet of the company for the financial year ended in March 2020:

According to the formula of the Current Ratio, we have:

As we can see that the current ratio of Reliance Industries was 0.62. It shows that there were not enough current assets in this company to clear off its short term debts.

But it does not completely mean that it is not worth investing. There are several other parameters that can indicate whether the company is good to invest in or not.

As a matter of fact, it was also seen that Reliance Industries got many large Institutional Investors for their company, e.g., Facebook, Silver Lake etc.

All these investments in Reliance Industries helped to clear its debt. And now, Reliance is on the verge of becoming a debt-free company. Moreover, during March, its P/E ratio was 18, which tells us that at that time, it was undervalued and was a good option for investment.                                             

*Disclaimer: This is not a recommendation either to buy or sell. It is for educational purposes only.

Importance of Current Ratio

• This ratio is used by creditors to evaluate whether a company can be offered short-term debts.
• It also provides information about the company's operating cycle.
• It shows a company's ability to convert its assets into cash to pay off its short-term liabilities.

Limitations of Current Ratio

While using the current ratio for analyzing a company for investment purposes, the following limitations must be kept in mind:

• The current ratio only tells us the quantity of assets and not the quality of assets.
• A current ratio can be easily manipulated by overvaluing the current assets.
• A current ratio cannot tell whether a company is receiving timely payments from its customers. 
• Several liabilities can also be neglected for just representing a good current ratio. 

The Bottom Line

As important as the current ratio is for analyzing a company's financial health, one should not make a solid assumption about its investment worth. A company with a current ratio of 2 or above does not always mean that it is a good company to invest in.

Moreover, it is not necessary that a current ratio always represents a company's complete liquidity or solvency. There are certain other factors also that are equally important while analyzing a company.

When analyzing a company for an investment opportunity, we must prioritise the quality of assets over the quantity of assets. Ultimately, it is important to remember that no single financial figure or ratio can be the sole parameter for defining its financial health and investment worth.

Such decisions must be taken, considering all possible factors and looking at the company from all different angles. Only then, can the investment be utilized to its fullest potential.