Current Ratio
The current ratio equals current assets divided by current liabilities. It indicates the amount of cash available at the balance sheet date plus the amount of other current assets the firm expects to turn into cash within one year of the balance sheet date (from collection of receivables and sale of inventory) relative to obligations coming due during the period. Large current ratios indicate substantial amounts of current assets are available to repay obligations coming due within the next year. Small ratios, on the other hand, indicate that current assets may not be sufficient to repay short-term obligations
The current ratio for PepsiCo at the end of 2012 is as follows
The current ratio equals current assets divided by current liabilities. It indicates the amount of cash available at the balance sheet date plus the amount of other current assets the firm expects to turn into cash within one year of the balance sheet date (from collection of receivables and sale of inventory) relative to obligations coming due during the period. Large current ratios indicate substantial amounts of current assets are available to repay obligations coming due within the next year. Small ratios, on the other hand, indicate that current assets may not be sufficient to repay short-term obligations
The current ratio for PepsiCo at the end of 2012 is as follows
The current ratio for PepsiCo was 0.96 at the end of 2011. Thus, PepsiCo experienced an increasing current ratio during the 2012, consistent with an improvement of its cash and near-cash assets relative to current liabilities
Banks, suppliers, and others that extend short-term credit to a firm generally prefer a current ratio in excess of 1.0, but current ratios are not evaluated in isolation and are assessed in the context of other factors affecting a firm’s liquidity. They typically evaluate the appropriate level of a firm’s current ratio based on the length of the firm’s operating cycle, the expected cash flows from operations, the extent to which the firm has noncurrent assets that could be used for liquidity if necessary, the extent to which the firm’s current liabilities do not require cash outflows (such as liabilities for deferred revenues), and similar factors. Prior to the 1980s, the average current ratios for most industries exceeded 2.0. As interest rates increased in the early 1980s, firms attempted to stretch their accounts payable and use suppliers to finance a greater portion of their working capital needs (that is, receivables and inventories). Also, firms increasingly instituted just-in-time inventory systems that reduced the amount of raw materials and finished goods inventories. two factors, current ratios began moving in the direction of 1.0. Current ratios hovering around this level, or even just below 1.0, are now common. Although this directional movement suggests an increase in short-term liquidity risk, most investors view this level of risk as tolerable
Wide variation exists in current ratios across firms and industries, as evident in thevdescriptive statistics on current ratios in Appendix D. Therefore, you should considervseveral additional interpretive issues when evaluating the current ratio
Banks, suppliers, and others that extend short-term credit to a firm generally prefer a current ratio in excess of 1.0, but current ratios are not evaluated in isolation and are assessed in the context of other factors affecting a firm’s liquidity. They typically evaluate the appropriate level of a firm’s current ratio based on the length of the firm’s operating cycle, the expected cash flows from operations, the extent to which the firm has noncurrent assets that could be used for liquidity if necessary, the extent to which the firm’s current liabilities do not require cash outflows (such as liabilities for deferred revenues), and similar factors. Prior to the 1980s, the average current ratios for most industries exceeded 2.0. As interest rates increased in the early 1980s, firms attempted to stretch their accounts payable and use suppliers to finance a greater portion of their working capital needs (that is, receivables and inventories). Also, firms increasingly instituted just-in-time inventory systems that reduced the amount of raw materials and finished goods inventories. two factors, current ratios began moving in the direction of 1.0. Current ratios hovering around this level, or even just below 1.0, are now common. Although this directional movement suggests an increase in short-term liquidity risk, most investors view this level of risk as tolerable
Wide variation exists in current ratios across firms and industries, as evident in thevdescriptive statistics on current ratios in Appendix D. Therefore, you should considervseveral additional interpretive issues when evaluating the current ratio
- An increase of equal amounts in current assets and current liabilities (for example, purchasing inventory on account) results in a decrease in the current ratio when the ratio is greater than 1.0 before the transaction but an increase in the current ratio when it is less than 1.0 before the transaction. Similar interpretive difficulties arise when current assets and current liabilities decrease by equal amounts. With current ratios for many firms now in the neighborhood of 1.0, this concern with the current ratio has greater significance
- For certain firms, a very high current ratio is not desirable and may accompany poor business conditions, whereas a very low or decreasing ratio may be a sign of financial health, and may accompany profitable operations. For example, during a recession, firms may encounter difficulties in selling inventories and collecting receivables, causing the current ratio to increase to higher levels due to the growth in receivables and inventory. In a boom period, the reverse can occur.
- A firm with a very strong ability to generate large and stable amounts of cash flows from operations may function very effectively with a low current ratio, whereas a firm with slow or volatile cash flows from operations may prefer to carry a higher current ratio.
- The current ratio is susceptible to window dressing; that is, management can take deliberate steps prior to the balance sheet date to produce a better current ratio than is the normal or average ratio for the period. For example, toward the end of the period, a firm may accelerate purchases of inventory on account (if the current ratio is less than 1.0) or delay such purchases (if the current ratio is greater than 1.0) in an effort to improve the current ratio. Alternatively, a firm may collect loans previously made to officers, classified as noncurrent assets, and use the proceeds to reduce current liabilities.
Despite these interpretive issues with the current ratio, you will find widespread use of the current ratio as a measure of short-term liquidity risk. Empirical studies (discussed later in this chapter) of bond default, bankruptcy, and other conditions of financial distress have found that the current ratio has strong predictive power for costly financial outcomes
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