Current Ratio

Current ratio = Current Assets Current Liabilities

Example :

Click here to see the source of data

Starworld Group 2021 2022 2023 Cash 60 85 112 Accounts Receivable 232 278 362 Inventory 97 116 151 Prepaid expenses 35 20 55 Total current assets 424 499 680 Bank payable 126 179 383 Accounts Payable 116 139 181 Accruals 36 45 55 Total current liabilities 278 363 619 Current ratio 1.525 1.374 1.098

There are 2 traditional, very popular and widely accepted liquidity ratios (current ratio and quick ratio) Let's recall them just to emphasize their weaknesses and how misleading they can be sometimes for managers

The idea :

The higher this ratio is, the more liquid the company is.

But there are at least 3 weaknesses in this ratio :

• Not all current assets can be quickly transformed into liquidity to meet maturing short term obligations (inventories).
• This ratio can improve for the wrong reasons :
  • If a firm is facing difficulties due to an economic recession,it is quite possible that its inventories are going to pile up
  • Customers, being themselves in trouble, are increasing the period of credit, therefore increasing the Accounts Receivables of the company
  • Are we going to conclude that the liquidity of the firm is improving ? No it is just the reverse.
  • How can we trust a liquidity ratio which is improving when the liquidity of the firm is deterioring ?
• This a very static measure, since it is not using any flows but only amounts at some specific time

   

Sources :

Interpreting and using financial statements, 1999, Marc Bertonèche, Ph. D. in Finance from the Northwestern University, Professor at the Bordeaux University and at Sciences-PO Paris, Visiting Professor at Harvard Business School and Oxford University.

Corporate Finance Course, Bernard Jaquier, Professor in Economics & Finance, Lausanne, Switzerland, 2024