Advantages and Disadvantages of Current Ratio

The current ratio is one of the most useful ratios in financial analysis as it helps to gauge the liquidity position of the business. In simple words, it shows a company’s ability to convert its assets into cash to pay off its short-term liabilities. The article discusses different advantages and disadvantages of current ratio.

It is calculated as a ratio of a company’s current assets to its current liabilities. The current ratio is widely used by banks and financial institutions while sanctioning loans to the companies and therefore this is a vital ratio for any company. There are different ways of analyzing and improving current ratio to portray a better liquidity position of a company.

Along with knowing how to analyze and improve current ratio, it is important to know the advantages and disadvantages of using current ratio

Advantages of Current Ratio

  • Current ratio helps in understanding how cash rich a company is. It helps us gauge the short-term financial strength of a company. Higher the ratio, more stable the company is. Lower the ratio, greater is the risk of liquidity associated with the company.
  • The current ratio gives an idea of a company’s operating cycle. It helps in understanding how efficient the company is in selling off its products; that is, how quickly is the company able to convert its inventory or current assets into cash. Knowing this, a company can optimize its production. This enables the company to plan inventory storage mechanisms and optimize the overhead costs.
  • Current ratio shows the management’s efficiency in meeting the creditor’s demands. It also gives an understanding of working capital management/requirement of the company.

Disadvantages of Current Ratio

  • Using this ratio on a standalone basis may not be sufficient to analyze the liquidity position of the company as it relies on the amount of current assets instead of the quality of the asset.
  • Current ratio includes inventory in the calculation, which may lead to overestimation of the liquidity position in many cases. In companies, where higher inventory exists due to fewer sales or obsolete nature of the product; taking inventory under calculation may lead to displaying incorrect liquidity health of the company.
  • In companies where sales are seasonal; current ratio may show lower numbers in some months and higher current ratio in the other.
  • Current Ratio may be impacted due to change in inventory valuation methodology by the company. Such will not be a case while using the quick ratio since it does not consider inventory at all.
  • An equal increase or decrease in the current assets and current liabilities can change the ratio. Hence, an overdraft against inventory can cause the current ratio to change. Hence, it is very easy to manipulate current ratio.

Conclusion:

The current ratio is a very good indicator of liquidity position of the company amid certain limitations which one needs to keep in mind before using and interpreting the ratio. One can look to use Acid test ratio that does away with some limitations of current ratio; however any of these ratios needs to be used in comparison/conjunction with other measures to interpret the short-term solvency of the company.

References:

Last updated on : July 13th, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Cash Ratio
  • Difference between Breakeven Point vs. Margin of Safety
    Difference between Breakeven Point vs. Margin of …
  • Operating Margin Ratio
    Operating Margin Ratio
  • Defensive Interval Ratio
    Defensive Interval Ratio
  • Advantages and Application of Ratio Analysis
    Advantages and Application of Ratio Analysis
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook


    Related pages


    leasor definitionwho is the lessor in a lease agreementshareholder versus stakeholdermanagerial accounting variance analysisdebits and credits exampleswhat is the formula for asset turnovercomments on financial ratio analysiswhat are redeemable preference sharesturnover ratio meaningcash ratio interpretationwhat are the differences between financial and managerial accountinghow to find notes payablehow to calculate operating cyclewhat is the definition of bookkeepingdisadvantages of weighted average methodinventory management abc analysissemi finished goods examplesaccounting debit definitionmeaning of capital employedwhat is preferential sharesmargin of safety ratio calculatorlading definewacc for companiesdefine degree of operating leverageworking capital cycle pptzero balance budgetingwhat is the difference between managerial accounting and financial accountinggaap book valueaccounting for leases journal entrieswhy npv is better than irrflotation cost calculatordefine floating rate bondmaximization of shareholders wealthwhat is the difference between a stockholder and a shareholderresidual dividend policynon constant growth formuladebt equity ratio tells us aboutformula of debtors turnover ratiodividend growth model excelebitda vs net incomedisadvantages of cash flow forecastequity cost of capital calculatorweighted average profitability index formulairrevocable letter of credit costdifferent types of mergers and acquisitionslc advising bankinventory turnover examplesmodigliani theoryconstant growth rate formulapresent net value formularoce return on capital employeddebit credit ledgernon constant growth stock valuationimpairment ifrsdebit credit rules accountingstandby lc definitioncapm costoperating income formula managerial accountingaccounting turnover formuladebtors days formulaexplain capital rationingwhy is npv better than irraccelerated method of depreciationcompute payback periodwhat is fictitious assetswhat does credit and debit mean in accountingbudgeting methodologiespik couponirr fomuladifference between horizontal and vertical mergerzero based budget exampleirrevocable transferable letter of credit