Current ratio

Current ratio is the ratio of current assets to current liabilities. Current assets and liabilities change frequently, unlike long term assets such as land and building or long term liabilities like equity capital or long term loans. The word 'current' denotes that the particular asset or liability is expected to be converted into cash or paid for with cash within twelve months or over the operating cycle, whichever is longer. Thus goods sold on credit, where payment is expected within the period mentioned above, are current assets and material and services purchased on credit in similar manner are current liabilities.

In a manufacturing company the day to day activities of most of the employees affect either the current assets or the current liabilities. Raw material is bought and stocked, finished goods are produced and sold either against cash or on credit, services of all kinds are used, payments are made to suppliers and money is collected from customers. All such activities and many more keep the 'current' assets and liabilities constantly in a flux. Financial managers spend great amount of time managing current assets and current liabilities. Arranging short term financing, negotiating favorable credit terms, controlling the movement of cash, managing inventory etc. consume lot of time and they are all connected with either current assets or current liabilities.

Supposing a moment is frozen in the working of a company and all current liabilities and current assets are calculated, the management, shareholders and also the creditors would be pleased to see current assets exceeding the current liabilities. Such a situation ensures that all day to day creditors can be satisfied without touching the fixed assets of the company. In short, the current ratio indicates the ease with which trade creditors can be satisfied.

Advantages of settling trade credits with ease are many but the most important is the enhancement of credibility. It gives the company the power to negotiate better deals with their supplier, which helps in bringing down the cost. The intangible gain is improved reputation and goodwill. Interestingly, because it is apparent so easily in an annual report, all those who study an annual report take a look at current assets and liabilities at first pass and form an impression.

Who apart, from the management, would be interested in knowing the current ratio? The investors and the Bank credit officers definitely are. Banks seek the data on very regular basis, especially that of sundry debtors and inventory because on that basis they make short term funds available. Investors are interested in finding out the health of the company. To some extent, large suppliers also take a look at the current ratio before agreeing to supply goods.

For an analyst though, the mere computation of the current ratio is not enough, as he also wants to know the composition of current assets and liabilities. Current assets mainly consist of raw material inventory, cash in bank, sundry or trade debtors, and loans and advances made by the company. Current liabilities consist of trade credits, loans and advances taken from customers and others and any other liability of temporary nature and some provisions.

Inventory of raw material, though termed as current asset is really speaking not of much use in settling trade credits. Manufacturing companies rarely carry raw material that can be traded easily in the open market. Raw forgings, castings and other parts, which are specially made for the company are of no use to others. They get converted into cash profitably, only if they are converted into finished goods and sold. Analysts therefore are wary of large inventories, which tend to inflate the current assets and create a false picture. Therefore a ratio called 'Quick ratio' was invented which is a ratio of current assets without inventory, to current liabilities. Thinking here is clear. Creditors wish their credits to be settled in cash and not in kind and therefore assets which are in the form of cash or those which can be easily converted into cash are worth their salt. Raw material inventory can not be readily converted into cash and therefore is to be ignored.

From such a point of view, cash in bank and those cash investments that can be easily liquidated are most welcome.

Sundry debtors form major part of current assets but they are not very liquid. As a farmer would put it, it is grain in the field and not in the silo. These are with the customers to whom goods have been sold on credit and as the saying goes there is many a slip between the cup and the lip. Large sundry debts will improve the current ratio but hidden behind the size could be the fact that debts are not being collected efficiently. Activity of collecting debts frequently causes friction between sales and finance people. A very high ratio could indicate that suppliers are weary of granting credits and company is forced to settle them in cash while the customers are enjoying long credit periods. It could also mean that a company would be facing a cash crunch sooner or later.

So then, what is a good value of current ratio? It changes from industry to industry and also from company to company within a sector. One thing is certain, a ratio of less than one is not desirable, for obvious reasons. As a very general rule and at a superficial level, a ratio of two is satisfactory. Ratio of less than two should invite investigation.

It would be worth our while to see some actual figures from published reports. Four companies are chosen and their figures are presented below in a table. All are leading companies in their field. The companies are Bajaj Auto Ltd., Cummins India Ltd., Great Eastern Shipping Co. Ltd. and LIC Housing Finance Ltd. All figures are in Rs. Million. Accounting year is also mentioned for the sake of correctness.

Company	Acct. Yr.	C/Assets	C/Liablities	C/Ratio	Inventory	Q/Ratio
Bajaj Auto	99-2000	23,730.80	17,403.74	1.36	2,611.26	1.21
Cummins	98-99	3,546.18	1,113.44	3.18	1,176.61	2.13
GESCO	98-99	5,750.45	2,527.74	2.27	1,085.83	1.84
LIC Hsg	99-2000	3,960.65	2,043.50	1.94	Nil	1.94
Figures in Rs million

At first glance Cummins and GESCO show a current ratio higher than 2, while the other two show it below 2. The quick ratio shows that with BAL the fall is very little (about 11%) and with LHF there is no change as there is no inventory. LHF has a note in its annual report, which explains that all stock purchases are treated as expenditure for the year without making any provision for stock at the end of the year. The stock mainly consists of stationary and forms etc.

With a current ratio lower than the norm, are these two companies under any stress to settle their creditors? Though such an analysis is out of the scope of this article, in passing we will mention that further analysis of BAL is necessary. With LIC Housing finance a glance at the current assets tells that the assets cover the liabilities sufficiently.

What about the other two companies? They are showing a very healthy current as well as quick ratio, yet I recommend going deeper. Composition of debtors is always worth studying. GESCO informs that out of Rs. 1,465 Million of sundry debts Rs. 371.3 Million, about 25%, are of over six months and, considered good. An analyst may want to make a provision for these debts or at least a part and reduce the current assets accordingly. Sundry debts have a habit of degenerating into bad debts very fast and the effort spent in recovering such bad debts reduces their value. Moreover companies don't like to accept that debts are 'bad' and continue spending money to recover them. If all sundry debts 'over six months but considered good' are removed then the current assets stand reduced to Rs. 5379.15 Million and the current ratio gets reduced to 2.13.

Difference between current assets and liabilities is termed as working capital. Imagine a hypothetical situation where all current assets consist of sundry debts and all current liabilities consist of sundry credits. If the debt is recovered in full the credits can also be settled in full and the money left over will be available for day to day spending. In real life the matters are more complex. If the difference between assets and liabilities is made available in advance, daily affairs of the company can go on unhindered and as the debts are recovered, the money can be used to settle credits as well as repayment. This is how banks tend to view the situation. Such a view also gives rise to some bad practices. Some companies tend to raise false invoices to 'create' sundry assets in order to overcome temporary cash crunch. Shareholders can rest easy with large well-audited companies but even then studying the current assets and liabilities in detail helps.

Many years ago I met a businessman, from a community known for its business acumen, who told me that he did not believe in sundry debtors? He sold goods on cash and purchased raw material on credit. So his current assets showed zero sundry debtors but plenty of cash sitting in bank and drawing interest. Many cash rich companies have similar situation. For the accountant of the company this is real Nirvana.