Friday, July 25, 2008

Why The Importance of the Current Ratio?

The first ratio an accounting student learns is the current ratio. You calculate the current ratio by dividing total current assets (generally cash, short-term investments, receivables, inventories, and prepaid expenses) by total current liabilities (generally short-term debt, accounts payable, accrued liabilities and taxes). For example, if you have $300,000 of current assets, and $150,000 of current liabilities, you have a current ratio of ($300,000 / $150,000) 2:1. In other words, there are $2 of current assets available to retire each $1 of current liabilities.

In fact, 2:1 is generally considered a good sign; that's what they teach you in the textbooks as well.

The writers of many bank loan agreements have also drunk the current ratio Kool-Aid. Not all loan agreements have financial covenants in them, but we do see them quite often. Quite often you will see one requiring the borrower to maintain a current ratio of at least 2:1.

The problem is that this ratio is easily manipulated.

Say it is December 15, and Acme Company is approaching its December 31 year-end. It has a loan agreement that requires it to maintain a current ratio of 2:1. Uh oh - Acme has current assets of $250,000 and current liabilities of $150,000. Its current ratio is currently (pun kind of intended) 1.67:1. If it maintains that ratio through the end of the year, it will violate its covenant with the bank, which at its worst could result in a default on the loan, and the bank wants to repaid right away.

So what can Acme do about this? Pay off $50,000 of current liabilities. It now has $200,000 of current assets (they used cash after all) and $100,000 of current liabilities. Its current ratio becomes 2:1.

Even better - pay off $75,000 of current liabilities. Now the current ratio becomes 2.33:1. Or pay off $100,000 of current liabilities to get a current ratio of 3:1.

This is just nonsense. Working capital (current assets less current liabilities) in all cases is $100,000. All Acme has done is game the system a little (presuming of course it has sufficient cash) to be in compliance.

Wouldn't just focusing on working capital make more sense? That requires the company to focus in improving its revenues and reduce its costs. And wouldn't that make the bank feel more secure?

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