Advantages and Disadvantages of Current Ratio
A company’s working capital plays a crucial role in its cash management. This term represents the residual current assets after deducting its current liabilities. Usually, companies use working capital to cover their short-term obligations. On top of that, it plays a critical role in how companies operate and fund their daily activities. For stakeholders, it is highly significant due to its impact on finances.
Working capital management is a crucial part of any company’s processes. It measures a company’s liquidity position and ability to meet short-term obligations. On top of that, it shows the resources available for usage in operations. Usually, companies prefer to have more current assets than current liabilities. This way, they have a margin to cover the obligations arising from operations.
Several financial metrics allow companies and stakeholders to measure the working capital position. These ratios may differ in their interpretation and meaning. However, they show a company’s liquidity position. Most of these ratios fall under the liquidity ratios. These ratios are a part of the financial or accounting metrics that companies may use. One of these metrics includes the current ratio.
What is the Current Ratio?
The current ratio measures a company’s ability to meet its short-term obligations. Usually, it gauges if the company satisfy those obligations arising within a year. Although the current ratio takes a short-term approach, it can be highly crucial. It considers the weight of total current assets versus total current liabilities. This way, it indicates a company’s financial health and liquidity position.
The current ratio is a straightforward metric that most stakeholders find critical to evaluate a company. It is among the liquidity ratios that companies use to measure liquidity position. Essentially, it considers the working capital position and how companies manage those resources. As mentioned, these resources include current assets. On top of that, the current liabilities that companies owe also play a role in the current ratio.
Simply put, the current ratio measures the relative magnitude of current assets to current liabilities. The higher this ratio is, the more preferable investors find it. In contrast, a low current ratio can indicate working capital management issues. Unlike other metrics, this ratio has a standard that most investors prefer. Usually, a good current ratio falls between 1.5 and 3. However, other factors may play a role in it.
How to calculate the Current Ratio?
The current ratio calculation considers a company’s working capital. As mentioned, it usually includes two factors or metrics. These consist of the current assets and current liabilities. These metrics are crucial in calculating the current ratio and working capital. Investors can measure this ratio by dividing the current assets by the current liabilities.
With the above definition, investors can use the following current ratio formula.
Current Ratio = Current Assets / Current Liabilities
The first component of the current ratio is a company’s current assets. This figure is available on the balance sheet. Similarly, it represents the value of all assets that companies expect to convert into cash within a year. In other words, it includes liquid assets that last shorter than 12 months. Current assets consist of cash and cash equivalents, accounts receivable, prepaid expenses, inventories, etc.
On the other hand, the current ratio also requires the current liabilities. It includes the short-term obligations arising from operations. Companies record amounts owed to third parties payable within the next 12 months under this category. Like the current assets, the current liabilities are also available in the balance sheet. Usually, it includes accounts payable, accrued expenses, short-term borrowings, and taxes owed.
Both components allow shareholders to calculate the current ratio. As mentioned, investors prefer this ratio to be between 1.5 and 3. However, industrial and market factors may play a crucial role in it. If this ratio is lower than 1, it implies that the current assets are lower than its current liabilities. In contrast, any number above 1 means the opposite.
What are the Advantages and Disadvantages of the Current Ratio that You Should Know?
The current ratio is a highly critical ratio for many companies. Through this ratio, investors can calculate a company’s liquidity position. On top of that, it is also crucial for internal use. When companies measure their working capital, the current ratio can be beneficial to calculate. There are many advantages and disadvantages of the current ratio. Some of these include the following.
Advantage – Easy to calculate
One of the most crucial advantages of the current ratio is that it is easy to calculate. Investors can obtain both metrics used in its calculation from the balance sheet. On top of that, these factors do not require any adjustments. Instead, investors can put those metrics in the above formula for current assets to measure it. Almost anyone can gauge the current ratio through a company’s financial statement.
Disadvantage – Not easy to compare
The current ratio includes a relative measurement of current assets and current liabilities. It presents a number that helps investors gauge a company’s liquidity position. However, comparing this number with other companies is not straightforward. Several factors may impact whether the current ratio will be high or low. Therefore, it may not be as comparable as some other financial ratios.
Advantage – Easy to interpret
As mentioned, a higher current ratio is preferred. Usually, companies aim to keep this ratio above 1.5. This feature makes interpreting the current ratio much easier. The current ratio doesn’t present a futile amount. Furthermore, the meaning of this ratio is also straightforward. If it starts falling, companies risk facing financial difficulties in the future.
Disadvantage – Includes inventory
The current ratio measures a company’s liquidity position. For that, it compares its liquid assets to its short-term obligations. These assets include inventories as well. However, some stocks may not be easily convertible into cash. Therefore, they may not be as liquid. When companies include those inventories in the current asset calculation, it may produce an inaccurate result.
Advantage – Gives an idea of the operating cycle
The current ratio provides an idea of a company’s operating cycle. In essence, it allows investors to understand how efficiently a company sells its products. This process begins with the acquisition of raw materials. Similarly, it ends when companies receive the payment for selling finished goods. In that regard, the current ratio plays a crucial role in explaining the operating cycle.
Disadvantage – Can be manipulated
Companies can manipulate the current ratio in several ways. For example, they can increase their current assets by changing the classification. On top of that, they can reduce the current liabilities as well. In some instances, companies can also make those alterations close to the year-end. Therefore, it may not present a company’s working capital management accurately.
The current ratio is one of the liquidity ratios that consider a company’s working capital. This ratio measures the relative magnitude of the current assets to the current liabilities. Usually, investors prefer this ratio to be higher. However, several factors may contribute to it. There are several advantages and disadvantages of the current ratio.