Liquidity and Working Capital Current Ratio Current Ratio- Limitations: If liquidity is the ability to meet cash outflows with adequate cash inflows, then does the current ratio: Measure and predict the pattern of future cash inflows and outflows? Measure the adequacy of future cash inflows to outflows? Answer is generally no to both these questions Current ratio ati Is a static measure Does not have a causal relation to future cash inflows
Current Ratio — Limitations: If liquidity is the ability to meet cash outflows with adequate cash inflows, then does the current ratio: ➢ Measure and predict the pattern of future cash inflows and outflows? ➢ Measure the adequacy of future cash inflows to outflows? Answer is generally no to both these questions Current ratio ➢ Is a static measure ➢ Does not have a causal relation to future cash inflows Liquidity and Working Capital Current Ratio
Liquidity and Working Capital Current Ratio Current Ratio-Limitations in numerator Adjustments often needed to counter various limitations such as . Failure to reflect open lines of credit Adjust securities' valuation since the balance sheet date Reflect revolving nature of accounts receivable Recognize profit margin in inventory s Adjust inventory values to market Remove deferred charges of dubious liquidity from prepaid expenses
Current Ratio — Limitations in Numerator Adjustments often needed to counter various limitations such as ❖ Failure to reflect open lines of credit ❖ Adjust securities’ valuation since the balance sheet date ❖ Reflect revolving nature of accounts receivable ❖ Recognize profit margin in inventory ❖ Adjust inventory values to market ❖ Remove deferred charges of dubious liquidity from prepaid expenses Liquidity and Working Capital Current Ratio
Liquidity and Working Capital Current Ratio Three important qualifications 1. Liquidity depends to a large extent on prospective cash flows 2. No direct relation between working capital account balances and patterns of future cash flows 3. Managerial policies are directed primarily at efficient and profitable asset utilization and secondly at liquidity 4. Cash flow forecasts and pro forma financial statements are preferred over the current ratio for liquidity and solvency analysis 5. Current ratio is a static measure of the ability of current assets to satisfy current liabilities
Three important qualifications 1. Liquidity depends to a large extent on prospective cash flows 2. No direct relation between working capital account balances and patterns of future cash flows 3. Managerial policies are directed primarily at efficient and profitable asset utilization and secondly at liquidity 4. Cash flow forecasts and pro forma financial statements are preferred over the current ratio for liquidity and solvency analysis 5. Current ratio is a static measure of the ability of current assets to satisfy current liabilities Liquidity and Working Capital Current Ratio
Liquidity and Working Capital Current Ratio Two important elements are integral to use of the current ratio 1. Quality of both current assets and current liabilities 2 Turnover rate of both current assets and current liabilities
Two important elements are integral to use of the current ratio 1. Quality of both current assets and current liabilities 2. Turnover rate of both current assets and current liabilities Liquidity and Working Capital Current Ratio
Liquidity and Working Capital Current Ratio -Applications Comparative Analysis Two useful tools in analyzing the trend in the current ratio Trend analysis - components of working capital and the current ratio are converted to indexes and examined over time Common-size analysis -composition of current assets is examined over time
Comparative Analysis Two useful tools in analyzing the trend in the current ratio Trend analysis -- components of working capital and the current ratio are converted to indexes and examined over time Common-size analysis -- composition of current assets is examined over time Liquidity and Working Capital Current Ratio - Applications