How can the current ratio be misinterpreted by investors?

By Jean Folger AAA
A:

The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability to pay short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The current ratio is calculated by dividing current assets by current liabilities.

While current ratio can be used to evaluate a company’s financial health, the results can be misleading. One reason for this is that a high current ratio is not necessarily a good thing, and, similarly, a low current ratio is not automatically a bad thing. For example, assume company ABC has current assets of $1,000, current liabilities of $400 and a resulting current ratio of 2.5. Company XYZ, on the other hand, has current assets of $400, current liabilities of $400, and a resulting current ratio of 1.0. At first glance it may seem that company ABC is a better financial position to meets its obligations.

Let’s dig a little deeper. Assume both companies’ current liabilities have a payment period average of 30 days. Company ABC – with the higher current ratio – needs 180 days to collect its account receivables, and turns its inventory only twice per year. Company XYZ – with the lower current ratio – collects cash from its customers and turns its inventory 26 times per year. Despite the fact that XYZ has a lower ratio, it is in a better position and more liquid because of its faster cash conversion. Company ABC, though it has a higher current ratio, would have trouble operating because bills are coming in faster than cash.

The inventory component in the current ratio can also produce misleading results. For example, if a company’s current assets include a high percentage of inventory assets, the assets may be difficult to liquidate, and therefore, the company may not be as liquid as it appears in its current ratio.

As with other financial ratios, it is more useful to compare various companies within the same industry than to look at only one company, or to attempt to compare companies from different industries. In addition, investors should consider more than one ratio (or number) when making investment decisions since one figure cannot provide a comprehensive view of the company.

RELATED FAQS

  1. How are contingent liabilities reflected on a balance sheet

    Find out how to identify, treat and report contingent liabilities on the balance sheet. See how the U.S. GAAP requires contingent ...
  2. What's the difference between the coverage ratio and the levered free cash flow to ...

    Learn the differences between the equity evaluation metric, the levered free cash flow to enterprise value ratio and various ...
  3. Why is work in progress (WIP) considered a current asset in accounting?

    Find out why accountants consider work in progress (WIP) to be a current asset on the balance sheet for financial accounting ...
  4. What are some ways a company can improve on its Return on Capital Employed (ROCE)?

    Discover how the return on capital employed ratio is used by analysts and investors to measure profitability, and how a company ...
RELATED TERMS
  1. Current Ratio

    A liquidity ratio that measures a company's ability to pay short-term ...
  2. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative ...
  3. Nonadmitted Balance

    An item on an insurer’s balance sheet that represents reinsured ...
  4. Best's Capital Adequacy Relativity (BCAR)

    A rating of an insurance company’s balance sheet strength. Best’s ...
  5. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  6. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...

You May Also Like

Related Articles
  1. Investing

    Using The Current Ratio

  2. Fundamental Analysis

    Reviewing Liabilities On The Balance ...

  3. Fundamental Analysis

    Dynamic Current Ratio: What It Is And ...

  4. Forex Education

    5 Tips For Reading A Balance Sheet

  5. Term

    Current Ratio

Trading Center