Using Financial Statements 17by current liabilities, and is known as the current ratio. It is expressed as “2.5
to 1” or “2.51” or just “2.5.” Keeping the current ratio from dropping below
1 is the bare minimum to indicate survival, but it lacks any margin of safety. A
company must maintain a reasonable margin of safety, or cushion, because the
current ratio, like all financial ratios, is only a rough approximation. For this
reason, in most cases a current ratio of 2 or more just begins to provide credi-
ble ev idence of liquidity.
An example of a current ratio can be found in the current sections of the
balance sheets shown earlier in this chapter:
Nutrivite
Selected Sections of Projected Balance Sheet
as of December 31, 200X
Assets Liabilities and EquityCash $ 40,600 Accounts payable $40,000
Inventory 80,000
Current assets $120,600 Current liabilities $40,000
The current ratio is 120,600/40,000, or 3. This is only a rough approximation for
several reasons. First, a company can, quite legitimately, improve its current
ratio. In the earlier case of Nutrivite, assume the business wanted its balance
sheet to ref lect a higher current ratio. One way to do so would be to pay off
$20,000 on the bank loan on December 31. This would reduce current assets to
$100,600 and current liabilities to $20,000. Then the current ratio is changed
to $100,600/$20,000, or 5. By perfectly legitimate means, the current ratio has
been improved from 3 to 5. This technique is widely used by companies that
want to put their best foot for ward in the balance sheet, and it always works
provided that the current ratio was greater than 1 to start with.
Current assets usually include:
- Cash and Cash Equivalents.
- Securities expected to become liquid by maturing or being sold within
a year. - Accounts Receivable (which Nutrivite did not have, because it did not sell
to its customers on credit).
•Inventory.
Current liabilities usually include:- Accounts Payable.
- Other current payables, such as taxes, wages, or insurance.
- The current portion of long-term debt.
Some items included in Current Assets need a further explanation.
These are: