Question

The ABX company applied for a line of credit to finance the production operations of a new article. The bank denied the request because in its analysis of the financial statements the current ratio was less than 2

Why do you think the bank considered that the current rate less than 2 was not adequate? What other factors could be considered when evaluating a current rate less than 2 as adequate?

In preparing your answer, explain what the current rate of a company measures and its importance for effective financial planning.

Answer 1

Current Ratio of a Company measures its short term solvency or its ability to service the debts which are payable within a year. It compares current assets of a company to its current liabilities.

Constantly maintaining required current ratio is essential to the company's fundamental financial health and operational success as a business. It increases operational efficiency of the company. Keeping current ratio higher than required will make the company keep excess funds as idle thus losing the revenues from productive use. Proper current ratio is a financial strategy which helps the company not only covering its financial obligations but also boosts its earnings. It indicates efficiency of Company's operating cycle. Maintaining proper current ratio is a tool for effective financial planning.

The bank may be based on one or more of the following grounds thought that current ratio of less than 2 was not adequate:

• Current ratio of less than 2 poses serious short term solvency issues for the Company and likelihood of its failure to meet short term obligations.
• Most industries and companies, Lenders use as general bench marking for short term solvency as current ratio of 2.
• The Industry in which company operates requires a standard current ratio of 2 for smooth functioning.
• Company's current assets consists substantial amount of slow moving inventory and long time holding of debtor balances and quality of current assets in terms of realisation into Cash is slow.
• Operating cycle of the company is long and this will create problems for payment of current obligations.
• Bank is not assured itself about the company's abilility to service line of credit.

The bank may consider one or more of the following grounds in deciding that current ratio of less than 2 was adequate:

• The Company's debtors balances are low or Company don't offer credit terms. So weightage of current liabilities is more.
• Company's operating cycle is faster than credit periods offered by creditors.
• Industry avaerage requirement for current ratio is less than 2.
• Line of credit is secured by a mortagage or pledge.
• Current ratio is slightly less than 2.
• Quick assets are more than current liabilities.