Question

Explain why a 2:1 current ratio might not be adequate for a company even though the rule of thumb states it is.

Answer 1

Current assets are the cash and other assets that are expected to be converted into cash within one year.

Current Liabilities are the amount due to be paid within one year.

Current ratio measures the liquidity of the company by dividing the current assets with the current liabilities. It is a liquidity ratio that measures whether the firm has enough resources to meet its obligations.

An ideal Current ratio is said to be within 1.2 to 2 which means that the business has twice more current assets compared to the current liabilities. A current ratio below 1 means that the company doesn't have sufficient resources to pay its debts.

But if the value of current ratio is 2:1 it also means that the company may not be efficiently using its current assets especially cash or its financing options. It depicts the inability of the firm in managing its working capital.

Also when the current ratio is 2:1 an equal increase in current assets and current liabilities will decrease the current ratio as a whole.

For instance,

If the current assets are 100000 and current liabilities are 50000

Current ratio = 100000/50000= 2:1

If both current assets and current liabilities increase by 50000,new current ratio is 150000/100000= 1.5:1.

This can also be the reason why 2:1 ratio may not be acceptable by companies.