In order to meet immediate obligations as they arise in the regular course of business, companies often rely on short term finance (i.e. loans and credit facilities that must be repaid in less than 1 year).
The short term liabilities for a business consist of items such as accounts payable, taxes, utilities payable and other accrued expenses. In order to deal with such expenses, companies regularly approach their financiers and dip into their overdraft facilities. While long term debt to equity ratio measures the extent to which a company relies on external debt to meet its capital requirements, it does not tell anything about the short term financial position of the company (i.e. the working capital position). It is therefore important to look at this aspect separately to assess the solvency or liquidity position of the company.
In order to appreciate whether the company is comfortably placed to meet its short term financial obligations, you need to keep a close eye on the proportion of:
- Current Assets
- Current Liabilities
Assessing short term financial position
The current ratio (arrived at by dividing the current assets by the current liabilities) is treated as a traditional measure to gauge a company’s liquidity position or its short term financial position. It calculates the amount of cash available in the form of assets which could be converted to cash within one year in order to pay debts that fall due during the same year.
For example, if a company has Rs. 10 million in current assets and Rs. 5 million in current liabilities, the current ratio would be 2 (10/5 = 2).
What should be considered as an acceptable current ratio?
The answer to that of course varies depending upon the industry in which the company operates as different types of enterprises have different cash conversion cycles, economic needs, and capital structure.
Purely from a liquidity perspective, a high current ratio is ALWAYS better than a lower current ratio, because a higher number indicates that the company has sufficient cash reserves to dip into to meet its short term obligations. However, the management has to balance the demands of earning the highest possible returns in future while maintaining sufficient liquidity. In other words, it is not always a matter of worry if the current ratio temporarily falls below 1 as companies often squeeze out cash sources to achieve its long term investment plan. On the contrary, a very high current ratio may indicate that the assets are not being employed in the most efficient manner by the management (i.e. this is when there are too many assets lying vacant on the books).
What will happen to a company which suffers from a poor short term financial position?
Such company is finding it difficult to meet its obligations towards suppliers/vendors etc. If this situation continues, the suppliers will not supply the raw materials for production which will hamper business. Poor liquidity position can bring upon many challenges, which could even result in liquidation if not addressed properly.
IMPORTANT: Irrespective of the reasons, a low current ratio should raise a red flag as it indicates that there is a strain on the short term financial position of the company and therefore deserves detailed examination.