CURRENT RATIO

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm's current assets to its current liabilities. It is expressed as follows:

The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables)

The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses. If a company's current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets or its short-term financing facilities

Some types of businesses usually operate with a current ratio less than one. For example, if inventory turns over much more rapidly than the accounts payable become due, then the current ratio will be less than one. This can allow a firm to operate with a low current ratio.

NOTE:

however, that looking at the current ratio alone may not give a clear picture of a company’s liquidity. That’s because the ratio can be affected by a number of factors that could vary by industry or business. A company in an industry that keeps more inventory on hand may have the same current ratio as a company in an industry that typically maintains large accounts receivable. But the latter type of company might be in a better position to satisfy obligations in a pinch because it may be easier to convert the receivables to cash than to sell the inventory at full value.

Current assets are made up of cash and cash equivalents ('near cash'), accounts receivable and inventory, while current liabilities are the sum of short-term loans and accounts payable. The current ratio's normal range is between 0.5 and 2.0, but this liquidity ratio must be interpreted with caution. A high ratio could indicate that the company is sitting on too much cash, that it is owed a lot ofmoney by its customers or that it needs to operate with huge amounts of inventory. A low ratio does not necessarily mean the company is a risky creditor. It could mean the company operates in an industry where cash payment is standard, such as restaurants, which typically have

little or no accounts receivable, in an industry that operates without much inventory such as most service sector companies, or an industry in which customers pay slowly, such as the building sector.  

Retail

/*Financial ratios pulled from them measure operating performance and return on investment -- critical success factors. According to the Retail Owners Institute, poor financial health is the leading cause of retail failure. A retailer can avoid disaster by monitoring seven key ratios.*/

The current ratio measures a store's ability to pay its short-term debt. The equation divides current assets by current liabilities, found on the balance sheet. Retail Management Advisors recommends a current ratio of at least 2.0, adding that credit problems loom below a 1.5 ratio.

Service

 A low ratio does not necessarily mean the company is a risky creditor, industry that operates without much inventory so low ratio(1.29)

Heavy engg

ratio of less than 1 is a cause of concern, a company might struggle to sell o its stock of work in progress or finished goods quickly enough to pay of its creditors in a hurry 

Loads of inventory and advance payment is done so automatically current ratio is high

ACID TEST RATIOThe quick ratio is often referred to as the acid test because it offers a strong glimpse of your business's ability to liquidate assets.

ACID/quick ratio, which adds cash and accounts receivables from a balance sheet and divides that figure by current liabilities, provides an even better picture of a business solvency as it uses only the most liquid of assets of the business

Acid-Test Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

A common alternative formula is:

Acid-Test Ratio = (Current assets – Inventory) / Current Liabilities

Quick Ratio =Cash in hand + Cash at Bank + Receivables + Marketable Securities

Current Liabilities

In general, low or decreasing acid- test ratios generally suggest that a company is over-leveraged, struggling to maintain or grow sales, paying bills too quickly, or collecting receivables too slowly. On the other hand, a high or increasing acid-test ratio generally indicates that a company is experiencing solid top-line growth, quickly converting receivables into cash, and easily able to cover its financial obligations. Such companies often have faster inventory turnover and cash conversion cycles.

The more uncertain the business environment, the more likely that companies would maintain higher quick ratios. Conversely, where cash flows are stable and predictable, companies would seek to keep quick ratio at relatively lower levels. In any case, companies must achieve the right balance between liquidity risk arising from a low quick ratio and the risk of loss resulting from a high quick ratio. -

SERVICE

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RETAIL

Certain business sectors traditionally have a very low quick ratio such as the retail sector. Companies leading the retail sector are able to negotiate very favorable credit terms with suppliers due to their dominance in the market leading to relatively high current liabilities in comparison to their liquid assets. The business environment is also relatively stable in the retail sector and the expansion of operations is incremental which allow such companies to maintain lower acid test ratios without taking too much risk.