Why a company with high current ratio and net working capital would still have a liquidity...

Why a company with high current ratio and net working capital would still have a liquidity problem and not able to cover daily routine expenses.

Expert Solution

'Current ratio' is obtained by dividing 'current assets' by 'current liabilities' and 'net working capital' is the difference between the two.

Though a high current ratio or a large NWC might, at first, signify a comfortable liquidity position, in reality, it may not be so. For getting a more in depth idea, one has to look to the composition of current assets.

By definition, current assets include not only the very liquid components like cash & marketable securities but also the lesser liquid items like receivables and inventory.

Out of receivables and inventory, receivables are more liquid as they represent dues from credit sales that could be collected in due course. But inventory is the most illiquid of current assets as they are to be first converted to WIP, then to FG, then to sales and finally only to cash.

If the current assets contain a higher proportion of inventory and/or receivables, then the current ratio would be (as also NWC) high. Higher inventory might include obsolete or excess stock or non-moving stock and the receivables might contain old uncollectible debts. All these would make for a high current ratio or high NWC but not help liquidity.

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