Strategy

Advantages and Disadvantages of Using Current Ratio

by Faizul Haque

Current Ratio or CR (Also known as Working Capital Ratio, a class of Liquidity Ratios, also a member of profitability ratio) is a part of ratio analysis. By that we mean, it measures the liquidity capacity of an organization. It measures the organization’s capability to meet the debt obligations, the ability to pay off short-term (within 12 months) obligations to the debtors. The ratio is vastly used worldwide to measure liquidity capability. It is the most popular ratio among other liquidity ratios.

Current Ratio

The working capital ratio (a member of liquidity or profitability ratio) is a vastly used ratio that assesses a company’s capability to pay back its current liabilities with its current assets.

Accounts Used  for Calculating this Ratio

The accounts used to calculate this ratio are current assets and current liabilities. In the nominator, we use the current asset and in the denominator, we use current liabilities.

CR Formula

CR formula is easy to remember. If you understand the formula properly, you will understand the facts and the terms working behind the numbers. So, try to understand the formula at first. 

Current Ratio = Current Asset/Current Liabilities

current ratio formula
Picture: Formula

Example of Calculation Using the Formula

For example, suppose a grocery shop has 4 lakh BDT in cash, 2 lakh BDT in securities, 8 lakh BDT in inventory, 4 lakh BDT in accounts receivable and 12 lakh in liabilities. To calculate grocery shop’s CR, you would take the sum of its various assets and divide them by its liabilities, for a CR of 1.5.

Interpretation

Optimal ValueBetween 1.5 – 2.0
Moderate ValueAbove 1
Low-ValueBelow 1

As it shows the liquidity of the company, it has to have an optimal value. In most of the cases, the optimal value is between 1.5 and 2.  If it is in between 1.5 and 2, the company is considered to be a healthy company/business. In general, it indicates that the company has a high capability to meet its short-term obligations with its current assets, the financial strength is high.

But what if it is too low (Perhaps below 1)? It tells you that the capability of meeting short-term obligations is very low. Therefore, the company is not financially too strong to meet its short-term liabilities (12 months).

What if it is too high? maybe above 2 or 3,4? It means the current asset is much higher than the current liabilities. The company is having a big amount of current assets on hand. Therefore, it is not using its current assets properly.

Important: Sometimes, some companies maintain low liquidity ratio without negatively affecting the financial strength. For a few cases, it actually depends on the business.

Advantages

  • Easy to use
  • Help to understand the current liquid position of the company
  • Help to know if the condition is going toward better or worse
  • Measure the strength of the company
  • One of the most useful ratios
  • Can be used as key ratio
  • Easy to compare with the same ratio of other years
  • Helps to understand the working cycle quickly and precisely
  • Give an idea about the portion of convertible short term asset (inventories, investment assets etc)
  • Understanding of working capital management

Disadvantage/Limitations

  • Cannot be used as a standalone ratio
  • Short-term assets like inventories may lessen accuracy in the calculation
  • Seasonal sales – sometimes CR is high and sometimes its low
  • The ratio perhaps is inaccurate in the case of inventories valuation
  • Very easy to manipulate the CR by changing the nominator and denominator (inventories)

Key Things to Remember 

  • Optimal value is in between 1.5 and 2
  • Cannot be used as standalone ratio
  • Should be used as time series manner
  • The more, the better cannot be always true

Other Liquidity Ratios to Measure Liquidity

  •  Quick Ratio
  • Acid Test
  • Working Capital Ratio