Question

The main ratio used by many financial analysts to examine a company's short-term liquidity risk is the current ratio. However, there are a number of problems that arise when this ratio is used to examine short-term liquidity risk that may make the current ratio less useful than initially thought. Discuss the interpretative problems of using the current ratio

Answer 1

Utilizing this proportion on an independent basis may not be adequate to investigate the liquidity position of the organization as it depends on the measure of current resources rather than the nature/ quality of the benefit.

Current ratio incorporates stock in the figuring, which may prompt overestimation of the liquidity position much of the time. In organizations, where higher stock exists because of less deals or old nature of the item; taking stock under figuring may prompt showing inaccurate liquidity strength of the organization.

In organizations where deals are occasional; current proportion may demonstrate bring down numbers in a few months and higher current proportion in the other.

Current Ratio might be affected because of progress in stock valuation method by the organization. Such won't be a case while utilizing the quick ratio since it doesn't think about stock by any means.

An equivalent increment or reduction in the present resources and current liabilities can change the proportion. Consequently, an overdraft against stock can make the present proportion change. Subsequently, it is easy to manipulate current ratio.