Question

Discuss the pros and cons of the following:

a) Company has current ratio of 2.5 and the industry average is 3.2;

b) Company has current ratio of 4.5 and the industry average is 3.2

Answer 1

A current ratio is calculated by dividing the current assets of a company by its current liabilities.

Any asset is termed as current if it is to be converted into cash and cash equivalents within a period of 12 months. An ideal current ratio is 2 : 1. This implies that the company can easily pay off its current obligations using the current assets. However, having a current ratio lower than the industry average means that the company may not be able to perform in line with its peer competitors.

Let us understand this concept in more detail taking the scenarios given in the question.

a) Company has current ratio of 2.5 and the industry average is 3.2

Pros - Since the ideal current ratio is considered 2 : 1, the said company is in safe territory because its current ratio is higher than the ideal expected. It can be said that the company is in a fair position to tackle its current obligations by utilizing the current assets.

Cons - Since the company's current ratio is less than the industry average, it implies that the company's risk is greater than the industry because the said company is not as liquid as their peers which might result in default or distress.

b) Company has current ratio of 4.5 and the industry average is 3.2

Pros - Since the ideal current ratio is considered 2 : 1, the said company is in safe territory because its current ratio is higher than the ideal expected. It can be said that the company is in a fair position to tackle its current obligations by utilizing the current assets.

Cons - A higher current ratio is an indicator of high receivables, inventory stores. Therefore, a higher current ratio than the industry can be alarming which might suggest that the company is unable to utilize its current assets as efficiently as required. A higher current ratio could be due to receivables long due or non-moving inventory.