Page 192 - Calculating Agriculture Cover 20191124 STUDENT - A

21-4 Profitability & Performance Measures CH 21]

Current Ratio. The relationship between current assets and current liabilities is called the
current ratio. This ratio is a balance sheet ratio. It is also referred to as the working capital ratio or
Efficiency ratio: bankers' ratio. The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to
Typically used to pay off its short-term liabilities (debt) with its current assets. The current ratio is an important
analyze how well a measure of liquidity because short-term liabilities are due within the next year. The computation
company uses its for this ratio is with the following equation:
assets and
Current Assets
liabilities internally. Current Ratio = —————————
An efficiency ratio Current Liabilities
can calculate the
turnover of Marketable securities, receivables, and inventories may decline in value and there is no
receivables, the assurance as to when they will be converted into cash. On the other hand, current liabilities
repayment of must be paid at their face value and at specific dates. It is desirable that current assets always
liabilities, the be materially in excess of current liabilities. Although there is no hard and fast rule, banks have
quantity and usage long considered 2:1 as the minimum satisfactory ratio.
of equity, and the The Current Ratio is a more dependable indication of solvency than Working Capital.
general use of
inventory and Example A: Dunbar is applying for a loan with his local bank to expand his business. The
machinery. bank asks for a balance sheet, Figure 21.1, to analyze his current debt levels. His
balance sheet reports $158,200 in current liabilities and $645,000 in current
assets. (a) What is Dunbar’s current ratio, and (b) is this sufficient to satisfy the

Solvency: The banks desired ratio of 2:1?
ability of a Solution algorithm:
company to meet Current Assets $645,000
its long-term debts (a) Current Ratio = ——–—————— = ————— = 4.1:1
and financial Current Liabilities $158,200
obligations. (b) Yes. The ratio is greater than the banks desired ratio of 2:1.
Solvency can be
an important Considering these facts alone a bank is more likely to grant short term loans to the Dunbar
measure of Cattle Company.
financial health,
since its one way Analysis: The current ratio allows lenders and investors to understand the liquidity of a
of demonstrating a
company’s ability company and how easily that company will be able to pay off its current liabilities. The ratio
to manage its expresses a firm’s current debt in terms of current assets. The Dunbar Cattle Company has a
operations into the ratio of 4.1:1 which means that it has 4.1 times more current assets than current liabilities.
foreseeable future Higher current ratios are always more favorable than lower current ratios as this indicates that
the firm can more easily meet its current debt obligations.

Example B: McFerrin farms and sells grains. Cheryl McFerrin is applying for a loan to increase
her grain storage capacity. The bank asks for a balance sheet on her business to
analyze her current debt levels. Her balance sheet reports $200,000 in current
liabilities and $50,000 in current assets. (a) What is Tina’s current ratio, and (b) is
this sufficient to satisfy the banks desired ratio of 2:1?

Solution algorithm:
Current Assets $50,000
(a) Current Ratio = ———————— = ———— = 0.25 : 1
Current Liabilities $200,000

(b) No. The ratio is under the banks minimum desired ratio of 2:1.

Acid-Test Ratio/Quick Ratio. This ratio compares a company's most short-term assets
to its most short-term liabilities to see if a company has enough cash to pay its immediate
liabilities, such as short-term debt. The acid-test ratio includes cash equivalents, and
receivables and disregards the rest of the current assets that take time to liquidate quickly such
as inventory. Inventory for sale, merchandise and finished goods, and marketable securities are
excluded for this calculation as they require buyers to sell; less liquid, an issue of time. Liquidity
then is how quickly an asset can be turned into cash. It is the Acid-Test Ratio that yields an
indication of this liquidity.
The relationship of quick assets to current liabilities is the acid-test ratio and is calculated
with the following equation:

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