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Limitations of Current Ratio

Updated on November 29, 2012

There are limitations to using the current ratio to assess liquidity. Because cash is the only acceptable means of payment, it is important to consider the composition of current assets and determine whether those listed as current asset can readily be converted to cash.

For example, if pre-paid expenses compose most ofthe current assets, the current ratio overstates the liquidity of the company because the prepaid expenses cannot be converted to cash to settle the liabilities.

Further, the current ratio cannot predict or indicate patterns of future cash flows, nor can it measure the adequacy of future liquidity. For example, if there is a significant amount of accounts receivable from one customer and that customer files for bankruptcy there would be significant delay in receiving the payment. Even though the current ratio is high because of the receivables, the debt paying ability of the company is compromised due to the nonco11ection ofa significant receivable.

The current ratio examines only the current relationship between current assets and current liabilities. Problems with liquidity will affect other aspects of the company’s financial situation and may ultimately affect the company’s ability to pay long-term obligations (solvency) or use its assets efficiently (operating activity). Traditionally, for a company in the manufacturing industry, a current ratio of 2.O or above is considered healthy. However, in the current economic environment of e-business, a lower current ratio is acceptable.

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