The accounting industry has undergone a variety of scandals over the years. The now infamous Enron incident and similar occurrences have dealt a major blow to the accounting profession and have left many wondering whether the information that companies provide about themselves are accurate representations. After all, the purpose of accounting is to provide meaningful and decisive information about a company to its interested parties. Whether this is the government, creditors, suppliers, shareholders or potential investors, all rely on the information that is provided to them by accounting systems and the related assurances that the accounting profession provides. Thus, in order to ensure proper financial analysis of a corporation, interested parties must become familiar with the window dressing techniques or window tactics that some corporations undertake.
One of the most important aspects to consider when analyzing a company is its liquidity or ability to meet its short term maturing obligations. Various financial ratios and measures have been devised to determine this ability. One of the most popular ratios that are used to quantify liquidity is the current ratio. The current ratio is calculated by dividing current assets by current liabilities. The resulting figure provides an indicator of a company’s ability to cover its current liabilities. The higher the ratio, the better position a company has to cover its maturing obligations. Thus, a ratio of 2:1 indicates that a company has 2 dollars in assets to cover 1 dollar in liabilities.
Current Ratio = Current Assets / Current Liabilities
Although easy to calculate and comprehend, the ratio leaves too much room for manipulation. Whether the current ratio is truly representative of a company’s short term paying abilities depends on the composition of its components. This deconstruction of the current ratio’s components must be both qualitative and quantitative in nature.
Qualitative:
In considering the make up of the current ratio we must consider that the current asset component may affect liquidity depending on its composition. Thus, the more the current asset component is made up of less liquid assets such as inventory and prepaid expenses, the less liquid the current ratio actually is. As a result, a ratio of 5:1 may not mean much if the assets that make up current assets are illiquid.
Quantitative:
A second precaution to take when analyzing the current ratio measure is to realize that it easily susceptible to changes in the numerator and denominator depending on management’s intentions. Thus, decreasing current liabilities by paying them off with current assets for the same amount will produce a more favorable ratio (Example1). On the other hand, increasing current assets through the use of current liabilities for same amount will produce a less favorable ratio (Example 2).
Example 1:
Before
Current Assets = 200
Current Liabilities = 100
Current Ratio = 2:1 = 2
After
ABC Corporation pays off 50 dollars of accounts payable with cash.
Current Assets = 150
Current Liabilities = 50
Current Ratio = 3:1 = 3
Example 2:
Before
Current Assets = 200
Current Liabilities = 100
Current Ratio = 2:1 = 2
After
ABC Corporation buys 100 dollars worth of inventory on credit.
Current Assets = 300
Current Liabilities = 200
Current Ratio = 3/2 = 1.5