Ratio Analysis

1. Definition
Current ratio, also known as liquidity ratio and working capital ratio, shows the proportion
of current assets of a business in relation to its current liabilities.

2. Formula
Current Ratio

Current Assets

Current Liabilities

3. Explanation
Current ratio expresses the extent to which the current liabilities of a business (i.e. liabilities
due to be settled within 12 months) are covered by its current assets (i.e. assets expected to be
realized within 12 months). A current ratio of 2 would mean that current assets are sufficient
to cover for twice the amount of a company's short term liabilities.

4. Example
ABC PLC has the following assets and liabilities as at 31st December 2012:
$m

$m

75
75

150

25
50
25
100

200

100
60

160

Non Current Assets

Goodwill
Fixed Assets
Current Assets
Cash in hand
Cash in bank
Inventory
Receivable
Current Liabilities
Trade payables
Income tax payables
Non Current Liabilities

Bank Loan
Deferred tax payable

50
25

75

Current ratio will be calculated as follows:

Current Ratio

Current Assets
Current Liabilities

200
160

1.25

5. Interpretation & Analysis

Current ratio is a measure of liquidity of a company at a certain date. It must be analyzed in
the context of the industry the company primarily relates to. The underlying trend of the ratio
must also be monitored over a period of time.
Generally, companies would aim to maintain a current ratio of at least 1 to ensure that the
value of their current assets cover at least the amount of their short term obligations.
However, a current ratio of greater than 1 provides additional cushion against unforeseeable
contingencies that may arise in the short term.
Businesses must analyze their working capital requirements and the level of risk they are
willing to accept when determining the target current ratio for their organization. A current
ratio that is higher than industry standards may suggest inefficient use of the resources tied up
in working capital of the organization that may instead be put into more profitable uses
elsewhere. Conversely, a current ratio that is lower than industry norms may be a risky
strategy that could entail liquidity problems for the company.
Current ratio must be analyzed over a period of time. Increase in current ratio over a period of
time may suggest improved liquidity of the company or a more conservative approach to
working capital management. A decreasing trend in the current ratio may suggest a
deteriorating liquidity position of the business or a leaner working capital cycle of the
company through the adoption of more efficient management practices. Time period analyses
of the current ratio must also consider seasonal fluctuations.

6. Industry standards
Current ratio must be analyzed in the context of the norms of a particular industry. What may
be considered normal in one industry may not be considered likewise in another sector.
Traditional manufacturing industries require significant working capital investment in
inventory, trade debtors, cash, etc, and therefore companies operating in such industries may
reasonably be expected to have current ratios of 2 or more.

However, with the advent of just in time management techniques, modern manufacturing
companies have managed to reduce the size of buffer inventory thereby leading to significant
reduction in working capital investment and hence lower current ratios.
In some industries, current ratio of lower than 1 might also be considered acceptable. This is
especially true of the retail sector which is dominated by giants such as Wal-Mart and Tesco.
This primarily stems from the fact that such retailers are able to negotiate long credit periods
with suppliers while offering little credit to customers leading to higher trade payables as
compared with trade receivables. Such retailers are also able to keep their own inventory
volumes to minimum through efficient supply chain management.
Current ratios of Wal-Mart Stores, Inc and Tesco PLC as per 2011 annual reports are 0.88
and 0.65 respectively.

7. Importance
Current ratio is the primary measure of a company's liquidity. Minimum levels of current ratio
are often defined in loan covenants to protect the interest of the lenders in the event of
deteriorating financial position of the borrowers. Financial regulations of various countries
also impose restrictions on financial institutions to lend credit facilities to potential borrowers
that have a current ratio which is lower than the defined limits.
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