A good investor uses various metric valuations to determine the right stock. Using a single metric valuation may mislead an investor because they may choose a stock that is risky and they end up making huge loses. It is advisable to have a wide range of information before making an investment decision hence investors should consider using various metric valuations. The current ratio is a liquidity measure but it has certain weaknesses hence it cannot be used alone to determine the liquidity of a business. The liquidity of a business is the ability of a business to meet short-term obligations. Liquid assets can easily be turned into cash. The ratio is a good measure of liquidity but it does not reflect the true liquidity position, and it must be used alongside other liquidity ratios.
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The current ratio is a good indicator of the operating cycle of a business. Investors can use this ratio to understand how quickly a company can turn inventory into cash. Some of the current assets such as inventory are not highly liquid. If a company has a high amount inventory in the current assets, then the current assets are not highly liquid. A company whose inventory can quickly turn into cash can increase its production because it can inventory is not taking long to sell. However, the ratio as a standalone measure cannot clearly indicate the operating cycle.
A company can have a high ratio because it is holding a high amount of stock. In such a scenario the high current ratio is not a good measure of liquidity because the current assets are not highly liquid. Including inventory overestimates the liquidity of a company. For instance, a company can have high rate inventory because it has low sales and the products have become obsolete. Including inventory in the liquidity measure does not display the health of the company. To improve on the current ratio as a measure of liquidity investor should use the quick ratio.
The quick ratio is a modification of the current ratio. The advantage of the current ratio is it subtracts the inventory hence it truly reflects the liquidity position of the company as opposed to the current ratio. The quick ratio is more effective because it is not affected by changes in inventory. The current ratio effectiveness is minimized because it is affected by changes in the stock valuation methodology. The quick ratio subtracts the inventory hence it only concentrates on liquid items of the balance sheet hence it displays the correct liquidity health of the company.
The current ratio is effective in showing if a company has adequate resources to cater for its liabilities in one year. A company is expected to meet the creditors’ demands. At any particular time, a company’s current assets are expected to be higher than the current liabilities. The acceptable current ratio for big companies is 3%. A healthy business should have a current ratio of between 1.5% and 3 %. If the current ratio is within this range, then this company has strong financial strength. Conversely, a company which has a current ratio that is lower than 1 has problems meeting current liabilities. A company that has a current ratio of 0.7 this means that the company current liabilities are more than the current assets and the company cannot meet its short-term obligations.
However, a high current ratio does not necessarily mean that a company is good financially and a low current ratio does not necessarily mean that the company is in problems. This makes the current ratio to be a complicated financial measure that is not straight forward. A high current ratio can indicate that the company is facing asset management issues. Basically, the current ratio is a division of current assets by liabilities. This means that if current assets can be high because the company is holding a high amount of cash or it is holding a high amount of inventory. A high current ratio indicates that a company is not managing its capital well.
Conversely, a low one does not reflect that accompany is facing problems. Some business can operate at a low current ratio but still be strong financially. Some companies can have a long-term revenue stream and use to borrow against the strong financial base to meet it current liabilities. Such a company has the ability to maintain a low current ratio and still met its current obligations.
Another scenario is when a company turns over inventory rapidly than other creditors. If the inventory is moving at a faster rate than the rate at which the company is paying creditors it is possible to have a low ratio since the company has low inventory. In such a scenario it is possible to have a low current ratio even though it does not reflect that the company is in a serious financial problem.
Current Ratio - Main Critiques
The current ratio reflects the liquidity of a company. It is a popular measure of liquidity. Over time, the current ratio has proved that it is not an effective measure of liquidity. It is not straightforward ratio, and it cannot be used alone to determine the liquidity of a company. It has to be used alongside the quick ratio to determine the liquidity of a company. The ratio's main weakness is the inclusion of stock. Companies understand that holding a high amount of stock increase the overhead cost of the company. The company has to incur holding and storage costs. Inventory is not highly liquid. A company can take long to turn inventory into cash.
The second issue with the ratio is interpretation is not straight forward. An investor can choose a company with a high current ratio, but this does not necessarily mean that the company is in a good financial position. A high current ratio indicates that the company is inefficient in managing the cash. It is holding a high amount of cash that can otherwise be invested in other business activities. A low ratio may not reflect that the company is in trouble. It can be an indication of the prowess of the company in handling management. As a result, the ratio does not reflect the correct liquidity of the company.
