For lenders, the Current Ratio is the staple measure of a borrower’s liquidity position. A good ratio shows that the inflows in the short term will easily take care of expected outflows, such as creditor payments. However, this is only a superficial analysis. The real story lies beneath the surface, where surprises may be lurking.
Spooky Enterprises and Freaky Industries were both happy. They had what the banker wanted—a perfect liquidity profile. Both had current assets of ₹10000 Mn and current liabilities of ₹8,000 Mn leading to a near-perfect 1.25 Current Ratio, suggesting they were equally capable of meeting their short-term obligations.
For lenders, the Current Ratio is the staple measure of a borrower’s liquidity position. A good ratio shows that the inflows in the short term will easily take care of expected outflows, such as creditor payments. However, this is only a superficial analysis. The real story lies beneath the surface, where surprises—or monsters—may be lurking.
There are situations where even a high Current Ratio shows only part of the picture and can even misguide sometimes. In this article, we explore a three-step process that can make our assessment of a borrower’s liquidity more robust and exhaustive, helping us build a qualitative view of the liquidity position.
Step 1: The Four-Headed Current Assets
The first step is to break down what makes up the Current Assets. Not all Current Assets are created equal, and their liquidity grading varies. Cash is king—it’s immediately available to meet liabilities. Receivables are next, depending on how quickly they can be collected. Inventory, on the other hand, can be a bit of a wildcard. It’s only as good as its ability to be converted into cash within reasonable time. Then there are Other Current Assets (OCA), often considered a “black box” that should typically be regarded as the least liquid, unless, of course, you know exactly where each sub-item stands.
Spooky’s Current Assets comprise of ₹2,000 Mn in cash, ₹5,000 Mn in receivables, and ₹3,000 Mn in inventory, while Freaky has only ₹500 in cash, ₹3,000 in receivables, and ₹6,500 in inventory. Even though both have the same Current Ratio, applying this concept of liquidity grading, we see that Spooky Enterprises has much better liquidity quality owing to its higher cash and receivables (assuming, of course, these are realisable).
So instead of relying on the consolidated Current Asset value, a simple breakdown can help determine quality of liquidity of a borrower.
Step 2: Something Moves Under the NWC Bed
Current Liabilities are a source for creating Current Assets. In turn, Current Assets bring back cash to help repay Current Liabilities. If this cycle continues smoothly, the company has a good operational liquidity. However, there are often factors beyond a company’s control that may lead to temporary delays in debtor realization or slowing inventory movement.
To overcome this, a good practice is to build part of your current assets from long-term sources, where you do not have the urgency of immediate payment and can therefore better manage such realization delays.
This is where an analysis of Net Working Capital (NWC) comes into play. NWC is the part of long-term sources (Equity+ Long Term Debt) on the balance sheet that is used for Current Asset creation. It’s essentially Long-Term Sources – Long-Term Obligations, or alternatively, the difference between Current Assets and Current Liabilities.
Current Ratio and NWC go hand in hand. The higher the Current Ratio, the higher the NWC. While higher NWC is a good sign, you still need to check under the bed.
Spooky and Freaky both have similar NWC (CA-CL) of ₹2,000 Mn. However, in the case of Spooky, this comes entirely from equity, while Freaky relies primarily on long-term borrowings. It’s no brainer that equity is a better source than debt.
In essence, we look at NWC as a good indicator of a company’s ability to absorb any realization delays, but we still need to go below the surface to assess the quality of NWC. From a liquidity point of view more equity funding Current Assets is better than more long term debt funding it.
Step 3: Operating Cycle—Is Fast One the Friendly Monster?
Now that you have formed a qualitative view, you may still encounter cases where the Current Ratio is stretched.
Assume Spooky had an increase in Current Liabilities to ₹9,000 Mn, leading to its Current Ratio dropping to 1.1, while Freaky maintained its previous number with a CR of 1.25. How do you take a call on Spooky? Should you reject it?
The point of evaluation in cases of deviation in Current Ratio is based on the Cash-flow velocity, or more simply, the Operating Cycle. Spooky has a cycle of 60 days compared to Freaky’s 180 days. It is obvious that Spooky realizes cash faster, which improves its ability to match payment days with receivable days. Additionally, since Freaky has a longer cycle, it takes longer to realize if there are any issues in its Current Assets, say a debtor gone bust, and by then, the time for corrective action may be gone.
A shorter operating cycle indicates a quicker cash conversion, which provides some comfort in accepting a lower Current Ratio. Conversely, businesses with long operating cycles need a higher Current Ratio benchmark and, more importantly, a much better NWC quality.
Conclusion: Monster Hunting?
The Current Ratio is widely used and for good reason-its simple and intuitive. But it can only do so much. It requires your monster hunting skills to form a real qualitative view of the liquidity position of the borrower. If your financial analysis remains superficial, focused only on well-lit, jazzed-up corners, the real issues will remain hidden. The real monster lurk under the bed, inside the cupboard, and in the dark corners.
Happy lending.
Disclaimer: The opinions expressed here are those of the author and does not reflect the views of FrankBanker.com
