Advantages and Disadvantages of Current Ratio
Current ratio is one of the tools used to evaluate the company’s liquidation by measuring the ability to use the current assets to pay off current liabilities. It also called the working capital ratio which measures the company’s short-term financial position. The investors pay more attention to this ratio as it shows the management’s ability to use the current asset to cover short obligations. If they fail to do so, company will face liquidity and even lead to bankruptcy.
Current Ratio Interpretation
|Current Ratio = Current Asset / Current Liabilities
- If current ratio greater than one, it means the company in good financial health. Its current assets are more than enough to pay for the current liabilities.
- If current ratio equal to one means the current asset equal to current liabilities. It is a neutral spot where current assets are just enough to cover the short term liabilities.
- If current ratio less than one, meaning the current liabilities are greater than the current asset. The company is in a high-risk position, if the current liabilities are due at the same time, the current assets are not enough to settle. It is a high risk of liquidation.
Advantages of Current Ratio
|Advantages of Current Ratio
|Measure company financial health
|It allows the investors to measure company health to respond to the short-term payable which will be due within a year.
|Easy to calculate
|As we can see in the formula above, the calculation of the current ratio is very simple. We do not need to extract data or interpreted any complicated information. We only need the standard balance sheet to find the current ratio.
|Easy to understand
|It has only three possible results which are less than, more than, or equal to one. It is not hard to understand even the people without accounting skills. Accountants also find it easy to explain to other people.
|Access companies liquidate
|The current ratio is one of the tools to access the company’s possibility of liquidation.
Weakness of current ratio
|Weakness of Current Ratio
|Difficult to compare between companies
|Even we use the same formula to calculate the current ratio, but comparing them from one to other companies is not easy. Due to the nature of the business, the level of current assets and current liabilities are not the same. As well as the ratio.
|Not all companies with a current ratio of more than one will be able to escape from liquidation. Some current assets may not be able to convert to cash on time.On the other hand, some company may rely on revenue to pay for the long term and short term payable, so the current ratio cannot measure their liquidate.
|Conflict of interest
|The management may try to keep a ratio of more than one to maintain a good ratio. They reject to make a new investment which can provide more profit in the future.