Current Ratio: a Worked Example

The question is simple: if the business stopped borrowing new money tomorrow, would what it is about to collect cover what it is about to pay? A lender asks it because the bank is one of the creditors in the second list. An overdraft, the next year's loan repayments and the interest all sit there beside the suppliers, the tax authority and the staff.

The two lists are drawn by accounting rules, not by the cash calendar. In accounts prepared under the international standards and their New Zealand and Australian versions, an asset is current if it will be realised within twelve months or within the business's normal operating cycle, so maturing wine or drying timber can be current although it will take more than a year to sell. UK statutory formats keep debtors falling due after more than one year inside current assets and show the long-dated part separately. Under those standards a loan is current unless, on the balance date, the business has a right to defer settling it for at least twelve months. UK accounts show loans as falling due within one year on a test of the same kind.

Three things move the ratio without any change in the business. An overdraft repayable on demand is current even if it has been renewed every year for a decade. A term loan's next twelve months of repayments are current, so the ratio drops each year a loan approaches maturity, and drops sharply in the year a facility expires unrefinanced. And a covenant breach on or before the balance date can make the whole loan current, because the lender could demand it; under the international standards a waiver agreed after the balance date does not undo that. A fourth movement is deliberate: paying suppliers out of cash the day before the balance date lifts a ratio that is already above 1.0, which is the window dressing a lender looks for in the month after.

A manufacturer of rural fencing wire and posts, constructed for this page like every figure in it, closes its year with US$8.6m of current assets: US$0.4m of cash, US$3.6m of trade debtors, US$4.4m of stock and US$0.2m of prepayments. Its current liabilities are US$5.4m: trade creditors, an overdraft, tax and accruals, and US$0.6m of term loan repayments due within the year. The rest of its US$3.6m term loan, US$3.0m, is shown as non-current.

The first adjustment is the lender's judgment, not the accountant's: US$1.1m of stock belongs to a product line the business stopped making, and US$0.5m of debtors are a farm supply chain's invoices under dispute. Neither is worthless, but neither will pay a supplier next quarter. The second adjustment is not a judgment at all. The breach happened before the balance date, the waiver came after it, and the accounts must show the loan as current. The business has not changed between 1.59 and 0.83 times. What has changed is that the reader has stopped assuming every current asset turns into cash and every non-current loan stays put. The levels are the example's, not a market norm.

The quick ratio takes stock out of the top line, so the gap between the two shows how much of the apparent cover depends on selling stock. For the fencing manufacturer, with US$4.4m of stock, the reported quick ratio is 4.2 ÷ 5.4, or 0.78 times. The cash conversion cycle explains the level: a supermarket paid at the till before it pays its suppliers can run below 1.0 times by design, while a contractor holding retentions and slow progress claims may need well above it.

Neither ratio says anything about the months between balance dates. A seasonal business can report a comfortable current ratio at a June year end and exhaust its facility in October, which is why a lender sets the balance sheet beside a monthly cash forecast and its low point, the liquidity headroom, rather than reading the balance sheet alone.

DEFINED IN ONE PARAGRAPH → · THE QUICK RATIO, WORKED → · DEBT CLASSIFICATION ON A BREACH →

The ratio rarely decides a credit on its own; its trend does more work. A ratio that has fallen for three years while sales grew points to overtrading or to suppliers being stretched, and a lender asks which. Some facility agreements carry a minimum current ratio or working capital covenant, and there the definitions decide the result: whether the covenant uses the accounts as published or excludes debt reclassified on a breach, and whether stock is counted at book value.

The second place it bites is the year end. A borrower close to a covenant level that will be tested on the balance date has reason to raise it with the lender before that date, because a waiver, or a grace period ending at least twelve months after the balance date, agreed by then can keep the loan non-current in accounts prepared under the international standards, while one agreed afterwards cannot. A lender that learns of the breach from the audited accounts reads a current ratio that tells it something about the relationship as well as the balance sheet.

HOW BANKS ASSESS A WORKING CAPITAL REQUEST → · LOAN COVENANTS, EXPLAINED →