Now I will introduce a concept to gauge the liquidity of a business. It deals with the company’s ability to pay its creditors on time. Typically we want to see a company with Current assets greater than Current liabilities. This ensures that it can pay off all its short term obligations, else the creditors may impose liquidation of the business to get their dues back, which is not a very rosy scenario.
To check this, a common ratio that is used is called CURRENT RATIO calculated as below:
Current assets/Current liabilities
As you would have rightly guessed by now, a current ratio greater than 1 shows a decent liquidity position. If this ratio is greater than 2, it provides an even better safety buffer from liquidation perspective.
It is important though to view this ratio with respect to the industry or company’s business as well. Sometimes a company has a strong bargaining position over its suppliers and uses the credit from suppliers to finance its own operations. In that case the company can run a current ratio under 1.
Let’s take the example of Proctor & Gamble, the famous FMCG company. Looking at their current assets and current liabilities as of June 2017, we can see that the company is effectively financing its inventory and receivables using the credit from its suppliers:
(All numbers in USD mm)
Chapter 14: Long term debt and other liabilities