Interpretation Homework Help

Interpretation

In the case of company A in the above example, the current ratio is 1.5 : 1. It implies that for every one rupee of current liabilities, current assets of one-and-half rupees are available to meet them. In other words, the current assets are one-and-half times the current liabilities. The current ratio of 3 : 1 for company B signifies that current assets are three-fold its short-term obligations. The liquidity position, as measured by the current ratio is better in the case of B as compared to A. This is because the safety margin in the former (200 per cent) is substantially higher than in the latter (50 per cent). A slight decline in the value of current assets will adversely affect the ability of firm A to meet its obligations and, therefore, from the viewpoint of creditors, it is a more risky venture. In contrast, there is a sufficient cushion in firm 13 and even with two-thirds shrinkage in the value of its assets, it will he able to meet its obligations in full. For the creditors the firm is less risky, The interpretation is in inter-firm comparison, the firm the higher current ratio has better liquidity/short-term solvency.

It is important to note that a very high ratio of current assets to current liabilities may be indicative of slack management practices as it might signal excessive. Inventories for the current requirements and poor credit management in terms of overextended accounts receivable. At the same time. the firm may not be making full use of its current borrowing capacity. Therefore, a firm should have a reasonable current ratio.

Although there is no hard and fast rule, conventionally, a current ratio of 2 : 1 (current assets twice current liabilities) is considered satisfactory. The logic underlying the conventional rule is that even with a drop-out of 50· per cent (half) in the value of current assets, a firm can meet its obligations, that is, a 10 per cent margin of safety is assumed to be sufficient to ward off the worst of situations. The firm A of our example, having a current ratio of 1.5  can be interpreted, on the basis of the conventional rule, to be inadequately liquid from the point of view of its ability to always satisfy the claims of short-term creditors. The firm B, of course, is sufficiently liquid as its current ratio is 3 : 1. The rule of thumb (a current ratio of 2) cannot. however; be applied mechanically. What is a satisfactory ratio will differ depending on the development of the capital market and the availability of long-term funds to finance current assets, the nature of industry and so on.

In capital-rich countries, where long-term funds from the capital market are available in abundance. firms depend on current liabilities for financing a relatively small part of their current asset requirements and it is not unusual for a firm to finance two-thirds to three-quarters of its current assets by long-term sources. This policy of relying to a limited extent on short-term credit (current liabilities) is probably to avoid the difficulty in which the firms may be put by the creditors in tittles of temporary adversity. In underdeveloped countries, there is no alternative to relying heavily to short-term financing. Yet in view of the risk which such a practice entails, the firms would be well advised to keep the current liabilities within reasonable limits and finance a certain minimum part of the current assets by long-term sources.

Another factor which has a bearing on the current ratio is the nature of the industry. For instance, public utility companies generally have a very low current ratio, as normally such companies have very little need for current assets, The wholesale dealers, on the other hand, purchasing goods on cash basis or on credit basis for a very short period but selling to retailers on credit basis, require a higher current ratio. If, in our above example, firm A is a public utility, its liquidity position can be interpreted to be satisfactory even though its current ratio is less than the conventional norm. Thus; the standard norm of current ratio (2 : 1) may vary from industry to industry. However, a ratio of less than 1 : 1 would certainly be undesirable in any industry as at least some safety margin is required to protect the interest of the creditors and to provide Cushion to the firm in adverse circumstances.

The current ratio. though superior to NWC in measuring short-term financial solvency, is a rather crude measure of the liquidity of a firm. The limitation of current ratio arises from the fact that it is a quantitative rather than a qualitative index of liquidity. The term quantitative refers to the fact that it takes into account the total current assets without making any distinction between various types of current assets such as cash, inventories and so on. A qualitative measure takes into account the proportion of various types of current assets to the total current assets. A satisfactory measure of liquidity should consider the liquidity of the various current assets per se. As already mentioned, while current liabilities are fixed in the sense that they have to be paid in full in all circumstances, the current assets arc subject to shrinkage in value, for example, possibility of bad debts, unsuitability of inventory and so on. Moreover. some of the current assets are more liquid than others: cash is the most liquid of all; receivables are more liquid than inventories the last being the least liquid as they have to be sold before they are converted into receivables and, then, into cash. A firm with a higher percentage of its current assets in the form of cash would be more liquid, in the sense of being able to meet obligations as and when they become due, than one with a higher percentage of slow moving and unsaleable inventory and/or slow slaying receivables even though both have the same current ratio. In fact, the latter type of firm may encounter serious difficulties in paying its bills even though it may have a current ratio of 2 : 1, whereas the former may do well with a ratio lower than the conventional norm. Thus, the current ratio is not a conclusive index of the real liquidity of a firm. It fails to answer questions, such as, how liquid are the receivables and the inventory? What effect does the omission of inventory and prepaid expenses have on the liquidity of a firm? To answer these and related questions, an additional analysis of the quality of current assets is required. This is done in acid-test or quick ratio.

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