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Thursday, October 15, 2009

About Current Ratio and Quick Ratio

In-depth interpretation and analysis of financial ratios are best left to CAs and CFAs. For ordinary small investors, understanding the concepts behind the Current Ratio and the Quick Ratio enables a reasonable assessment of the financial health of a company.

If you are the kind of investor who only looks at the Profit and Loss statement in an Annual Report to check the Net Profit and Dividend amounts before tossing it in the dustbin, then you need to make a little more effort to become a better investor.

Look at the Cash Flow statement to check that the Cash Flow from Operating activities is positive. Then, calculate the Current and Quick ratios.

Current Ratio

This ratio is obtained by dividing the Current Assets figure in the Balance Sheet by the Current Liabilities. A good ratio is between 1.5 and 2. A ratio of 1.0 or less may mean that the company may face difficulty in meeting its short-term debt obligations. A ratio of 3 or more may not necessarily be better, as explained below.

Current Ratio

The range of Current Ratios are different for different industries and sectors. So, comparing the ratio with the company's competitors will give a better idea of industry norms and the company's position.

Current Assets typically comprise: inventories, cash and cash equivalents, accounts receivables (debtors), loans and advances.

Current Liabilities include: interest payments, accounts payables (creditors), provisions for payments of taxes, dividends, retirement and other benefits.

The Current Ratio indicates whether the company will be able to meet its payment obligations that become due within the year. It can do this by using the cash, or by collecting payments from its debtors, or by quickly turning over inventory to generate cash.

Too high a Current Ratio could mean:

(a) too much inventory - which may not be good because it may be valued at a cost which can't be realised later; this is particularly true of the retail industry, where inventories often need to be marked down for discount sales due to spoilage or change in fashion

(b) poor debt collection, or inadequate credit facilities from suppliers -indicating management inefficiency or a poor business model.

Quick Ratio

Due to concerns mentioned above, the Quick Ratio is often used as a better test of a company's liquidity position. That is why it is some times called a Liquidity Ratio or Acid Test Ratio.

The Quick Ratio is obtained by subtracting inventories from the Current Assets figure, before dividing by the Current Liabilities.

Quick Ratio

A ratio of 1.0 is considered good enough. It can be higher for certain industries, but too high a ratio may indicate management inefficiency.

What is the reason for subtracting inventories? The first reason has been mentioned already - the cost of inventories in the Balance Sheet may not reflect the real value. The second, and more important reason is that it may not be easy for a company to turn inventory into cash fast enough to meet payment obligations.

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