The current ratio is a type of liquidity ratio that measures a company’s ability to pay its short-term obligations with its current assets; it is also known as the working capital ratio. This ratio is used by investors and lenders to ascertain the ease at which a company can pay its current liabilities. To better understand the causes of a very high current ratio and its interpretation, it is best if we know what the components are.
High current ratio meaning
A high current ratio means that a company has enough liquid assets to cover its short-term liabilities; it indicates the company can easily meet its short-term obligations. However, a ratio that is too high may indicate that the company is not using its resources efficiently, as it has more cash than it needs, or there may be no sales. In the succeeding sections below, we will discuss some reasons why having a high current ratio may not always be good.
Generally speaking, a higher current ratio indicates a healthier business, because the company can pay its current liabilities with ease; but this is not always the case in reality.
Formula and components
The formula for the current ratio is current assets/current liabilities.
What are current assets?
The current assets are the items owned by the company that can easily be converted into cash within 1 year; these current assets include cash on hand, inventories, receivables, and short-term investments.
What are current liabilities?
The current liabilities are obligations that must be fulfilled within a year by a company to its creditors, suppliers, or others. These current liabilities include short-term loans and money expected to be paid to suppliers (known as payables).
What causes current ratio to increase?
An increment in any of the items that are part of the current assets could cause a high current ratio. This means an increase in inventories, cash on hand, and receivables could all cause an elevation of the current ratio. Also, a decrease in any of the current liabilities could increase the current ratio.
Let us take these components one by one to understand how each one affects the current ratio.
Increase in Cash on Hand
When the cash on hand of a company increases, it can cause a high current ratio. When this happens the company may decide to invest the excess cash, expand the business, or involve in the research and development of new products. If it decides not to invest or expand, the excess cash continues to accumulate and the result is a very high current ratio.
So a very high current ratio indicates possible excess cash that is not being put into use; this may be an indicator of poor management of assets.
Increase in receivables
Another cause of a high current ratio is an increase in the receivables; the receivable is the amount of money that is yet to be paid to a business but is expected to be paid within a short period of time (within a year). So what happens when more and more people or customers owe a company and have delayed payment? There would be an increase in the receivables and this will be counted as an increase in the current assets which will also cause the current ratio to increase as well.
So when you see a company with a very high working capital ratio, does that mean you should buy its stocks? What if the cause of the elevated current ratio is as a result of an increase in receivables? There is no guarantee that the customers may pay and so a high current ratio as a result of increased receivables may be deceptive.
Increase in inventories
The inventories are the raw materials needed for production or could also be the products themselves. A company may make more sales which makes the revenue increase and so there may be excess cash as explained above. But what happens when the products are piling up without sales being made? A recession could reduce sales, customers might find a new product, an alternative product, or might get a similar product somewhere that is cheaper. When this happens, the sales go down and the products pile up.
The piling of the products without selling might be mistaken by investors when they see the current ratio of the company is high. Therefore, a very high current ratio may indicate a hidden reduction in sales (the firm is carrying too much inventory).
Decrease in payables
Another tricky scenario that may lead to a high current ratio could be the company accumulating more debtors but at the same time, the company is paying its own debt back to creditors even before the receivables are paid. This will reduce the payables when the receivables are increasing, leading to a very high current ratio. The resultant effect is the same as the accumulation of receivables that many customers may not pay back totally or some may delay payments. So does it mean a higher current ratio is better? What would be your answer?
Does it mean a higher current ratio is better?
Theoretically, the higher the current ratio, the more capable the company is of paying its obligations, which is good. However, a high current ratio may also be indicative of inefficient management of assets and could be a sign that the company is not generating sales, which could inflate the inventories, leading to a higher current ratio. The reasons for this have been explained in the preceding section.
A real-life example of a high current ratio of a company
The expansion strategy of Arvin Mills in the mid-1990s almost cause bankruptcy because the company had a high current ratio of 6:1; this was caused by their large inventories which were accumulating because demand for their denim product was slowing down. The high current ratio was deceptive because the company was heavily indebted as a result of the loan it took to invest in a product that people were no more interested in. This shows that a high current ratio cannot be said to be good in all cases; it is better to know the cause before making any investment decision regarding the company.
What is considered a high current ratio?
What would be considered a high current ratio depends on the industry average for any given company; it is not static and changes with time, this means this year’s current ratio for a particular industry may be regarded as normal but may be regarded as high in the next year.
For example, from the table below, the average current ratio of animal and livestock production for the year 2017 was 3.81; it means a value of 10 in the same year would have been regarded as a very high current ratio. But by 2019 the average of 12.65 was regarded as normal; hence the current ratio across industries is dynamic and what would be regarded as high depends on the industry average for that particular year.
Table showing the yearly average current ratios by industries
|Animal and Livestock Production||5.25||12.65||8.29||3.81|
|Fishing and Hunting||23.59||0.72||1.92||0.31|
|Mining of Metals||1.55||0.92||0.38||0.14|
|Mining of Coal||1.63||1.65||1.51||0.97|
However, it is important to remember that the current ratio is only one financial metric and should not be used in isolation when assessing a company’s financial health.
Disadvantages of high current ratio
- A high working capital ratio may be misleading and does not show the true financial status of a company
- Another disadvantage of a company having a high current ratio means it is not efficiently using its assets and may be holding too much inventory. This can tie up working capital that could be better used elsewhere.
- A high current ratio may also make it difficult for a firm to obtain new financing, as lenders may view the company as being too risky because it may be carrying more inventory than necessary due to low sales.
Is having a high current ratio good?
Having a current ratio within or slightly higher than the industry average is good, but exceeding the higher limit for any specific industry could be deceptive and the cause should be determined.
A high current ratio can be interpreted as a company that is not using its available assets properly; whereas too low means there are more liabilities than the assets could cover.
Please note that a high current ratio does not indicate profitable operations because it measures liquidity and not the profitability of a business.
Basically, a high current ratio suggests that the firm has enough current assets to cover; but a very high current ratio will often be the result of a company with a large amount of cash on its balance sheet. While this is not necessarily a bad thing, it can indicate that the company is not effectively using its cash to generate profits or is not investing in growth opportunities. Additionally, a working capital ratio can also be the result of a company with high inventory levels. This can be problematic because it can tie up a lot of capital in inventory that may not sell quickly.