Advantages and Disadvantages of Current Ratio – The current ratio is a widely used ratio for financial analysis of a business because it provides an overall a business’s liquidity position. Simply put, it demonstrates a business’s potential to turn its assets into money in order to cover its short-term liabilities.
Let know the advantages and disadvantages of the current ratio.
Must Read – How to calculate the current ratio?
Advantages of Current Ratio
- The current ratio is often used to determine how surplus cash a business has over its short term loans. It assists us in determining a business’s short-term financial strength. The greater the ratio indicates how secure the organization is and lower ratio shows how risky a business is.
- The current ratio provides insight into a business’s operating cycle. It aids in determining how productive the business is at selling its products; that is, how easily the business can turn its inventory or current assets into cash. A business will maximize its performance if it is aware of this. This allows the organization to prepare material management mechanisms while still reducing overhead costs.
- The current ratio demonstrates management’s effectiveness in satisfying creditor obligations It also provides an overview of the business’s working capital management.
Disadvantages of Current Ratio
- This ratio on its own will never be adequate to measure the business’s liquidity status since it is based on the number of current assets rather than its quality.
- In certain situations, the current ratio contains inventory in its measure, that can contribute to an inaccuracy of the liquidity position. Taking inventory into account in businesses where large amounts of inventory occurs because of less sales or the outdated existence of the commodity may result in the business’s liquidity health being shown incorrectly.
- In businesses with seasonal revenues, you will see a lower current ratio in certain periods and a higher ratio in others.
- The business’s shift in inventory valuation approach could have an influence on the current ratio. This is not the issue when using the quick ratio because it does not take inventory into consideration.
- A difference in the ratio may be caused by an equivalent rise or reduction in current assets & current liabilities. As a result, an overdraft towards inventory will alter the current ratio. As a result, manipulating the current ratio is quite simple.
The current ratio is a really efficient tool to find a business’s liquidity position, although it has some drawbacks that must be considered while using and interpreting it. One option would be to use the acid test ratio, which eliminates a few limitations of the current ratio; furthermore, either of these ratios could be used in comparison with other methods to understand the business’s short-term solvency.