One of the most common measures of a company’s or farm’s financial short term ability to pay its obligations is the use of the current ratio. Theoretically, if an entity entirely ceased to generate income and if it were able to use all of its short term assets that can be turned into cash within the next 12 months to pay its entire short term obligations that are due within the next 12 months. Of course, this does not include any ongoing operational expenses. A ratio that is above 1.0 indicates that there are more current assets than current liabilities; the ratio below 1.0 indicates current liabilities are greater.
The larger question here is what is actually considered a current asset and what is actually a current liability. Just because it is listed on your client’s balance sheet does not really mean it fits the definition. One can see that if these numbers on either side a skewed, the ratio will not tell the correct short term position of the company. This post will look at several issues to consider when inspecting a current ratio.
First, consider the asset side of the equation. When you are looking at current assets, which ones are really current? Are there any items that are listed as a current asset that have a high probability of not being turned into cash in the foreseeable future? Are there any accounts that are uncollectable? Is there inventory or work in process that is stale and not marketable? Are any of the bank deposits pledged against other obligations that could not be used to satisfy any payables? Are there amounts due from the owners that will really not be paid back within the next year? It may be prudent to judge the current ratio after removing these items from the current assets.
There may also be intermediate term assets that could be turned into cash rather quickly in the case of a cash pinch. In farming, one item that could be considered is breeding stock or seed from harvested crops. In one bank I worked at, we would add to current assets either the extra amounts over the historical averages the customer would typically keep on hand. Another method may be to include a percentage of these intermediate term assets as current when running the current ratio. Clearly, items should not be added in here that if sold, would have a serious strain on the ability of the firm to generate income from its operations, such as selling equipment that is used in production.
On the liability side, one item that seems to be missed is the current portion of long term debt. I have seen many balance sheets that do not split the required principal payments due in the next 12 months from the long term debt balances. This understates the liabilities.
Some ways current liabilities may be overstated are when amounts due to the owners are listed as current, when the company has neither the will or ability to satisfy those debts in the next year. One option would be to treat this as equity, especially if you can get a subordination agreement to your loan. Other potential overstatements may be when debt that will not be paid in a year is stuck in the current side. This can happen with a line of credit a company has that it historically only can pay down to a certain level and no more. Sometimes, it may be wise to do a short term note with an amortized repayment to retire that form of permanent working capital.
The current ratio, as with all others, should never be used in a vacuum. There is no “holy grail” to be found that will give the lender a perfect method of monitoring and managing the performance of the company. All ratios are only clues to be followed to find the true reality of your company’s or farmer’s financial position.