Question

the current ratio (CR) measures the corporation’s ability to cover its short-term (ST) maturing liabilities with current assets (CA).

1. Is it better to have a higher CR to the industry average or is it better to have a lower CR? Explain your answer
2. When inventories increase, what effect will this have on the CR, potential profitability, and risk to the firm as a result? Explain.
3. When accounts payable (AP) drop, what effect will this have on the CR, potential profitability, and risk to the firm as a result? Explain.

Answer 1

Current Ratio is defined as CR = Current Assets (CA) /Current Liabilities (CL)

a) A higher CR is better from the liquidity point of view. A higher CR means that the organisation has sufficient CA to meet its CL. However, it adversely affects the profitability of the organisation as CA do not earn good income and higher CR meaning higher CA and thus profitability is adversely impacted

b) When inventories (a part of CA) increase, CR also increases and thus there is adverse impact on profitability i..e profitability decreases which may result in the firm not meeting its target returns or unsatisfied stakeholders.

c) When Accounts payables (a part of CL) drop, the CR increases and thus there is adverse impact on profitability i..e profitability decreases which may result in the firm not meeting its target returns or unsatisfied stakeholders.