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20-4 Profitability & Performance Measures CH 20]

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
bankers' ratio. The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to
Efficiency ratio: pay off its short-term liabilities (debt) with its current assets. The current ratio is an important
Typically used to measure of liquidity because short-term liabilities are due within the next year. The computation
analyze how well a for this ratio is with the following equation:
company uses its
assets and Current Assets
liabilities internally. Current Ratio = —————————
Current Liabilities
An efficiency ratio
can calculate the Marketable securities, receivables, and inventories may decline in value and there is no
turnover of assurance as to when they will be converted into cash. On the other hand, current liabilities
receivables, the must be paid at their face value and at specific dates. It is desirable that current assets always
repayment of be materially in excess of current liabilities. Although there is no hard and fast rule, banks have
liabilities, the long considered 2:1 as the minimum satisfactory ratio.
quantity and usage
of equity, and the The Current Ratio is a more dependable indication of solvency than Working Capital.
general use of Example A: Dunbar is applying for a loan with his local bank to expand his business. The
inventory and
machinery. bank asks for a balance sheet, Figure 20.1, to analyze his current debt levels. His
balance sheet reports $15,820 in current liabilities and $101,400 in current
assets. (a) What is Dunbar’s current ratio, and (b) is this sufficient to satisfy the
banks desired ratio of 2:1?
Solvency: The
ability of a Solution algorithm:
$101,400
Current Assets
company to meet (a) Current Ratio = ——–—————— = ————— = 6.4:1
its long-term debts Current Liabilities $15,820
and financial
obligations. (b) Yes. The ratio is greater than the banks desired ratio of 2:1.
Solvency can be Considering these facts alone a bank is more likely to grant short term loans to the Dunbar
an important
measure of 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 and how easily that company will be able to pay off its current liabilities. The ratio
company’s ability expresses a firm’s current debt in terms of current assets. The Dunbar Company has a ratio of
to manage its 6.4:1 which means that it has 6.4 times more current assets than current liabilities. Higher
operations into the current ratios are always more favorable than lower current ratios as this indicates that the firm
foreseeable future
can more easily meet its current debt obligations.

Example B: Tina’s Bike Shop sells bicycles and equipment to her community. She is applying
for a loan to expand her business by purchasing a commercial building. 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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