Current liquidity ratio / Working capital ratio

Last updated: 25.03.2016

Current liquidity ratio / Working capital ratio is one of liquidity indicators, which informs us how many times the firm would be able to pay its current liabilities, if it converts all of its current assets to cash.

 

Calculation formula

 

 

Disadvantages                                                                                                            

  • each component of current assets has different liquidity, which is not reflected by the current liquidity ratio formula
  • formula does not take into account different maturities of receivables and liabilities
  • does not make sense in the industries in which the companies must hold a large amount of stocks (e.g. trading businesses) - it is advisable to use indicators Quick or Cash ratio

 

Recommended values

ideal range is 1,5 - 2, but it depends on the industry a lot. It is especially higher for companies that must hold high inventory levels.

 

Interpretation

  • lower values ​​= lower ability to pay short-term obligations
  • too high values = possible inefficiencies - it is recommended to evaluate them together with turnover ratios
  • ideal values ​​shall thus be neither low nor high

 

Comparison

  • with the recommended values
  • however, some variations are possible by industry, type of company etc. - so it is very important to compare the indicators in time-series; it the company does not achieve the recommended values, but have done well without any problems, it can be then expected that it will continue to be successful with the same values in the future
  • appropriate is the comparison is with the industry average or with similar companies in the industry

 

Possible reasons for higher liquidity (the reasons for the lower liquidity can be applied conversely)

  • high levels of stocks (adequacy to be evaluated together with indicator Inventory period days)
    • this can be related to the branch (e.g. commercial companies tend to have high stock values)
    • high-quantity purchase of stocks due to favorable terms (discount), expected price increases or shortages
    • seasonal fluctuation in demand
    • stocks are overvalued - e.g. no legitimate provisions for inventories were made
    • the company holds excessive inventory. The adequacy of the level of stocks can be assessed by using indicators of activity (Inventory turnover ratio or Inventory period).
  • high receivable balances (adequacy to be evaluated together with indicator Receivables collection period)
    • high receivable recorded at the end of the year, which was not paid by the end of the year
    • uncollectable debt increased
    • higher maturity provided to customers, e.g. within acquisition or retention process
    • receivables are overvalued, for example, e.g. no legitimate provisions to receivables were made
  • low payable balances, e.g. due to effective supplier management. Adequacy of payables level an be evaluated by using indicator Days payable outstanding 
  • economic growth, during which is the liquidity lower, because liabilities are growing faster than current assets (14)

 



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