Don't Become Over Reliant on the Current Ratios
By Michael C. Dennis M.B.A.,
The current ratio provides and indication of the liquidity
of a business by comparing the dollar amount of current assets to
current liabilities. On a recent consulting assignment, I found that
the client was rejecting applicants with current ratios under a 1.25
to 1. The credit manager told me that the reason for the policy was
to 'weed out' applicants with cash flow problems. I made the following
comments and suggestions:
I asked my client to consider the fact that it was the actual
timing of cash inflows and outflows that determined whether or
not a customer would be able to pay invoices when they came due.
I asked them to view the current ratio is an indication of
a customer's liquidity. I suggested it was possible for a company
to have a low current ratio and have no trouble paying its bills.
One example of this would be a customer with a low current ratio
but a large working capital line of credit with its bank.
It would be important to see how the applicant has paid and
is currently paying trade creditors. It is also important to
know how large a line of credit they need.
I asked them to consider the current ratio as one factor
in the decision making process, and not to disqualify applicants
based on only one financial ratio.