Question

Let us say that long-term debt has an interest rate and short-term debt does not. Then why not finance your entire operation with non interest bearing short-term payables? Could save you money! What does the current ratio really measure and should it vary depending on the certainty of sales revenue? Note: textbooks probably get this wrong in my opinion.

Answer 1

Financing entire operation with non interest bearing short-term payables is not a feasible option. Although there is no interest to be paid, there is the obligation of repaying the debt every few days/weeks/months. This would seriously hamper the business operations as a huge amount of cash would be used to pay off debt periodically. A large proportion of cash flow from operations would be used up to repay debt, and this would create serious liquidity problems and not allow smooth running of business. On the other hand, long-term debt can be repaid over long time periods, and thus business can be run smoothly. Cash can be accumulated over time and debt repaid when it becomes due

Current ratio measures the short-term liquidity position of the business. It is an indication of whether a business has sufficient short-term funds to repay short-term obligations.

The current ratio should vary depending on certainty of sales revenue. However, this depends on cash sales or credit sales. If they are cash sales, then sales directly impact cash on hand, and therefore the current ratio. However if they are credit sales, then current ratio should vary depending on certainty of accounts receivable being received, and the certainty of them being received on time