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

Definiton: "Current ratio is a ratio which helps in ascertaining the company short term liquidity capability. In other words, it measures the ability of a company to pay its short term liabilties ( such as debt and accounts payable) with its short term assets(such as cash, inventory, account receivable, ets). In order to gauge this, the current ratio takes into account both both liquid and illiquid assets against current liabilities.

The more precise measure of company's short term liquidity ability are:- a) Quick Liquidty Ratio (also known as Acid Test ratio), b) Cash Asset Ratio (also known as Cash Ratio), c) Operating Cash Flow Ratio, etc.

Lets discuss the interpretative problems of using the current ratio are as follows:

1. It is not a perfect measure of company's financial health as it takes in account both liquid and illiquid asset for measurement of company short term liquidity capability. It only gives general overview or general estimate of company short term liquidity postion while performing working capital operations.

2. This ratio is only helpuful for ascertaining the smoothness of company in executing working capital operations.

3. The deficiency or limitation of using the current ratio is that it doesnot allow comparing different companies with one another having in different industries which is not in the case of quick liquidity ratio, cash ratio, etc.

4. From the point of interpretation, this current ratio in comparison to other ratio (mentioned above) gives less specificity with respect to company's liquidity ability as it takes in to account all of a company's current asset even those that cannot be easily liquidated leading people in misinterpreting the perfect liquidity position of a company.