Question

What is the current ratio? What is its purpose? How does this ratio measure liquidity?

Explain how the current ratio can be easily manipulated, providing a detailed illustration and example of how it can be manipulated.

Answer 1

Answer:

Current ratio is a liquidity ratio that quantifies an organization's capacity to pay its current liabilities or those due within one year. It tells investors how an organization can expand the current assets in its financials to fulfill its current liabilties and other short term debts.

Current ratio is calculated by comparing current assets and current liabilities. Current assets includes cash, inventories, accounts receivables and other assets that can be realized within one year whereas current liabilities include accounts payable, short term debts, taxes or other stautuory dues payable and other short term liabilities that are expected to be paid within an year. This is also known as working capital ratio.

Current Ratio = Current Assets / Current Liabilities

When the current ratio is less than 1, it means the current assets are not sufficient to meet its current liabilities whereas a current ratio more than 1 indicates that the currents assets of the company are sufficient to meet its current liabilities. However, current ratio at any one time is only a preview, it does not clearly represent the liquidity of the company.
Say for an example, a company has a current ratio of greater than 1, but its debtors/ accounts receivables are quite old which means that the payments from customers are recovered after a siginificant gap of time. Now, through current ratio, this fact is not disclosed. If analysts see through the current ratio, they will assume that the current assets are sufficient are to pay the company's short term obligations but in reality the financial position of the company is something different.
Similarily, this type of manipulation can be done through inventories also. There can be certain items in the inventory which cannot be sold as they have become outdated or obselete, but still the current ratio will include such stock value and will look acceptable to the analysts or investors.