© 2000 John Petroff

D- Current ratio

The current ratio is the best known ratio of financial analysis. It presents in relative terms what net working capital measures in absolute terms.

1)- Calculation of current ratio

The current ratio (CR) is calculated by dividing current assets (i.e. working capital) by current liabilities.

CR = Working Capital / Current Liabilities

The calculation of the ratio may require any of the modifications mentioned for working capital and current liabilities.

From Timken Balance Sheets, we take the values of current assets of $ 833.5 millions, and current liabilities of $ 557.6 millions in 1999, and obtain the current ratio for Timken in 1999 CR = 833.5 / 557.6 = 1.49 as can be verified in Timken Ratios.

See review question Q-8D1.1.

2)- Interpretation of current ratio meaning

A current ratio may have different meanings depending on the point of view of an analyst. It has a liquidating meaning - the ability to make all necessary payments today - which gives a measure of protection or cushion for lenders. But, lenders are not interested in receiving inventory in lieu of their claims, and they may look at the ratio as an indication that the firm is able to generate funds to make all needed payments in the future; thus, the ratio indicates whether the firm is likely to be a going concern. But, to infer such a meaning, the ratio cannot be looked upon as a single statistic, and it is necessary to analyze the degree of liquidity of the components of working capital, as it is done later in this chapter.

A general rule of thumb suggests that the current ratio should be close to 2. As can be seen in Table T-8.3, very few companies in the chosen sample meet the rule of thumb.

The food store and telephone company groups do not even come close to the supposed desirable level of 2. Only in pharmaceuticals, is there a large proportion of firms with adequate liquidity. Furthermore, if it is assumed that larger firms are the strongest firm, then the pharmaceutical companies statistics suggest that the improvement in liquidity is correlated with a position of strength in the industry. Unfortunately, such observation is not universal because just the contrary seems to take place in food stores and travel agencies: larger firms in these sectors have the worst liquidity. One may suspect that the easy access to credit of large food store chains and the eagerness of food manufacturers to place their products on store shelves explains their poor liquidity picture; indeed trade payables of large food stores (at 20%) are more than three times the size (6%) of those of small food stores.

See review questions Q-8D2.1 through Q-8D2.4.

3)- Current ratio determinants and limitations

Among the reasons the current ratio cannot be used as a single number is that the current ratio is affected by a combination of several factors, such as
- outside events affecting demand for the product (e.g. changes in customers' tastes)
- firm's strategies in sales, accounts receivable, inventories, production and purchasing
- managerial efficiency in implementing strategies
- financial strategy

The current ratio is definitely a convenient and mostly reliable tool measuring a company's level of liquidity. But, the variety of factors which affect it, suggests that one must be careful not to place too much trust in what the ratio seems to tell for the future. An analyst needs to predict the future. A current ratio is a static measure based on balance sheet amounts. To gain more insight, the analysis must always be done on a comparative basis over time. Deteriorating sales translate into mounting inventories, slow paying customers result in growing receivables. Both of these improve the current ratio. Thus, the current ratio is a poor predictive tool.

Another problem with the current ratio is that it does not relate components that are causally linked. Liabilities are not directly paid out of inventories or receivables. The first must be sold and the second collected before the proceeds can be used to make payments. Thus, it is most appropriate to use the tools that reveal how well the inventory is sold and receivables collected. As for the liabilities, measures of coverage which relate the funds from operations available to make the payments, and which are discussed in Chapter 11 Section B-4b, are also better criteria.

See review questions Q-8D3.1 through Q-8D3.4.

4)- Historical comparison

With increasing financial intermediation, availability of electronic transfers and improvements in inventory management, the proportion of current assets in balance sheet has been decreasing, and consequently the current ratio as well. According to the Financial Accounting Standards Board, current ratio average for all U.S. manufacturing Companies was 3.08 in 1950, and decreased to 1.75 in 1979. Since then it has fallen further to 1.3 in 1999, as shown in Table T-8.4 below. A parallel decline is observed in the quick ratio (from 1.8 in 1950 to 0.9 in 1979). The trend also reflects the shift in U.S. economic structure away from manufacturing where current assets are large, toward services where they are not.

Table T-8.4 presents values of liquidity ratios for eight aggregate sectors.

Table T-8.4 confirms the decline in current ratio and show that it has continued unabated reaching a median value of only 1.3 in 1999, which is less than half of what is was reported to be in 1950.

Comparing current ratios with the one foreign firm used as an example in the previous chapter may be interesting. The numbers will be taken from AO Boom GAAP Balance Sheet (rather than the Russian format balance sheet) to allow easier correspondence of components. For 1994, we find that current assets amount to 758,707 roubles and current liabilities 505,375 roubles. This gives a current ratio of CR = 758,707 / 505,375 = 1.5 AO Boom current ratio in 1994 is, therefore, exactly the same as the median of current ratio of retail operations in the United States.

See review question Q-8D4.1.

See research assignments R-8D.1 through R-8D.4.

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