The current ratio is a popular financial ratio used to test a company's liquidity (also referred to as its current or working capital position) by deriving the proportion of current assets available to cover current liabilities.
The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' current assets amounted to $1,575.60 (balance sheet), which is the numerator; while current liabilities amounted to $606.90 (balance sheet), which is the denominator. By dividing, the equation gives us a current ratio of 2.6.
The current ratio is used extensively in financial reporting. However, while easy to understand, it can be misleading in both a positive and negative sense - i.e., a high current ratio is not necessarily good, and a low current ratio is not necessarily bad (see chart below).
Here's why: Contrary to popular perception, the ubiquitous current ratio, as an indicator of liquidity, is flawed because it's conceptually based on the liquidation of all of a company's current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going concern. It's the time it takes to convert a company's working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio can be "misleading."
A simplistic, but accurate, comparison of two companies' current position will illustrate the weakness of relying on the current ratio or a working capital number (current assets minus current liabilities) as a sole indicator of liquidity:
Company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over current liabilities, a seemingly good current ratio, and working capital of $300. Company XYZ has no current asset/liability margin of safety, a weak current ratio, and no working capital.
However, to prove the point, what if: (1) both companies' current liabilities have an average payment period of 30 days; (2) Company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days); and (3) Company XYZ is paid cash by its customers, and its inventory turns over 24 times a year (every 15 days).
In this contrived example, Company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can't pay bills with working capital; you pay bills with cash! Company's XYZ's seemingly tight current position is, in effect, much more liquid because of its quicker cash conversion.
When looking at the current ratio, it is important that a company's current assets can cover its current liabilities; however, investors should be aware that this is not the whole story on company liquidity. Try to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities. This important perspective can be seen through the cash conversion cycle (read the chapter on CCC now). By digging deeper into the current assets, you will gain a greater understanding of a company's true liquidity.
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