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Don't Become Over Reliant on the Current Ratios
By Michael C. Dennis M.B.A., C.B.F.

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.

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