Is current ratio a good measure of liquidity?
Both the quick and current ratios are considered liquidity ratios because they measure a firm's short-term liquidity. Since the ratios use the firm's account receivables in their calculation, they're an excellent indicator of financial health and ability to meet its debt obligations.
Cash is the most liquid of assets, while tangible items are less liquid. The two main types of liquidity are market liquidity and accounting liquidity. Current, quick, and cash ratios are most commonly used to measure liquidity.
Answer and Explanation: It is true that the current ratio is a measure of liquidity. The current ratio uses the balance sheet to measure the ability of a company to use assets that will likely be used in the next period against obligations due in the same period.
In short, a “good” liquidity ratio is anything higher than 1. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment. Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3.
The major limitation of the current ratio is that it consists the inventory in its calculation while there is concern about the quality of inventory. Inventory will consist of finished products, incomplete products, raw materials and over-seasonal inventories that are not able to sell out anymore.
The current ratio is a comparison of a company's current assets to current liabilities that can be used to find its liquidity, usually as a comparison between companies in the same industry. Potential creditors use the current ratio to measure a company's ability to pay off short-term debt.
A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts. A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term liabilities.
Answer: This is because it includes quick assets that are most liquid and can be converted into cash in no time.
The reason being, in reality it is very difficult to convert inventory into cash in a short time period, without bearing losses. So, it is considered to be more dependable than current ratio.
The most common liquidity ratios are the current ratio and quick ratio. These are very useful ratios for calculating a company's ability to pay short term liabilities.
What is the most commonly used liquidity ratios?
Liquidity ratios are important financial metrics used to assess a company's ability to pay current debt obligations. The two most common liquidity ratios are the current ratio and the quick ratio.
If your current ratio is high, it means you have enough cash. The higher the ratio is, the more capable you are of paying off your debts. If your current ratio is low, it means you will have a difficult time paying your immediate debts and liabilities.
Cons: The calculation of the current ratio considers some of the non-liquid assets that cannot be converted into cash. The liquidity of these assets remains low which can affect the calculation of the current ratio.
Large current ratios are not always a good sign for investors. If the company's current ratio is too high it may indicate that the company is not efficiently using its current assets or its short-term financing facilities. If current liabilities exceed current assets the current ratio will be less than 1.
Current Ratio = Current Assets / Current Liabilities
The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company's balance sheet.
The bottom line
Both ratios are helpful for any financial analysis, but if you're more concerned with covering short-term debt within the next 90 days you should use the quick ratio. For a longer-term view of a company's liquidity, the current ratio provides a well-rounded view of assets vs liabilities.
Generally, a current ratio of 1.0 means that a company's liabilities do not exceed its liquid assets, though this can vary by industry. Numbers below 1.0 may be acceptable in industries where there's a quicker turnover in product and/or payment cycles are shorter.
Typically, the current ratio is used as a general metric of financial health since it shows a company's ability to pay off short-term debts. Within the current ratio, the assets and liabilities considered often have a timeframe. For example, liabilities in this ratio are usually due within one year.
The primary advantage for a company of using the current ratio is that it can help them measure their financial health. If the current ratio is less than one, it means that the firm needs to shore up its current assets to cover the immediate debt obligations or else it may face liquidity problems.
A high ratio (greater than 2.0) indicates excessive current assets in the form of inventory, and underemployed capital. A low ratio (less than 1.0) indicates difficulty to meet short-term financial obligations, and the inability to take advantage of opportunities requiring quick cash.
Why is current ratio misleading?
In contrast, the current ratio includes all of a company's current assets, including those that may not be as easily converted into cash, such as inventory, which can be a misleading representation of liquidity.
Improving Current Ratio
Delaying any capital purchases that would require any cash payments. Looking to see if any term loans can be re-amortized. Reducing the personal draw on the business. Selling any capital assets that are not generating a return to the business (use cash to reduce current debt).
But it's also important to remember that if your liquidity ratio is too high, it may indicate that you're keeping too much cash on hand and aren't allocating your capital effectively. Instead, you could use that cash to fund growth initiatives or investments, which will be more profitable in the long run.
A company's liquidity indicates its ability to pay debt obligations, or current liabilities, without having to raise external capital or take out loans. High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.
Although you want to have a high enough liquidity ratio to cover any expenses, keeping too much cash on hand can mean you aren't taking advantage of investment or growth opportunities, making your company stagnant.
