Generally, companies convert their current assets into money, which is used for covering their liabilities. Therefore, the estimation of the company's solvency and liquidity can be made through the comparison of these balance sheet entries.
Current Ratio – an indicator of a firm’s ability to pay its current liabilities from its current assets. The calculation formula represents current assets of a company, divided by its current liabilities. Currents assets include the part of the company's assets with the high or medium level of liquidity. The peculiarity of these assets is that they can be converted into money during one year (or a production cycle, in case it lasts longer than a year).
Obviously, the higher the ratio, the better it is for the company's creditors. However, from the point of view of the firm's owners and management, the current ratio that is higher than normative can be an indicator of an inefficient asset structure. Confirmation of this conclusion can be made through more detailed analysis of company's assets. Commonly even current ratio higher than 3 can indicate the process of involving unnecessary current assets to company's operations from the excessive finance resources. This causes the decline of indicators of the asset usage efficiency. Aside of that, excessive financial resources may cause the necessity of additional expenses for paying the interest. Considering this, applying the additional analysis of the company's finance structure would be reasonable. It would help to confirm (or object), that the enterprise has involved relatively too much of the expensive finance resources (long-term loans and stockholders' equity), while the cheap short-term resources are lacking.
As for lower than normative values of this ratio, they indicate the inability of a firm to meet its current obligations on time. This lowers the trust of creditors, suppliers, investors and partners. Furthermore, liquidity problems can cause the increase of credit resources cost, and thus direct financial loss. For a long period of time the value of 2 was considered as normative for the current ratio. But as planning and budgeting processes and the accounts receivable quality control were improving, the current liquidity of companies started decreasing. Worth mentioning that normative value of the current ratio often is conditional and depends on industry, seasonality, cooperation agreements with suppliers and other factors.
Considering everything said, the desirable value for the current ratio would range from 2 to 3, however for different businesses variations from 1,1 to 2 are acceptable.
At the same time, current ratio has some limitations. Some current assets, such as accounts receivable or inventories may not be truly liquid (accounts receivable of bad quality may not be convertible to cash within a business cycle or inventories may be difficult to sell for their real value). In this case even relatively high current ratio would not indicate the ability of a firm to meet its current liabilities on time. Considering this for getting a precise conclusion on company's liquidity it is recommended to analyze supplementary liquidity measures, such as calculating business ratios, that measure the liquidity of specific kinds of assets.
Resolving the problems with the current ratio exceeding the normative range:
To increase the current ratio value it is necessary to take some actions to increase the amount of current assets and to decrease the amount of current liabilities. One of the ways of decreasing the current liabilities amount is the negotiation about the extension of the loan period.
Current Ratio = Current Assets ÷ Current Liabilities
Current Ratio (Year 1) = 656 ÷ 464 = 1,41
Current Ratio (Year 2) = 766 ÷ 911 = 0,84
Current ratio was 1,41 in year 1, meaning that company was able to pay its current liabilities from its current assets, having 1,41 times as many current assets as current liabilities. In year 2 current ratio has declined to an unacceptable level of 0,84, indicating company’s problems with paying its suppliers and creditors on time.
The ratio is calculated through dividing the company's current assets by its current liabilities. Values lower than normative indicate the inability of a firm to meet its liabilities to suppliers, partners, creditors on time.