what is the major limitation of the current ratio as a measure of a firm's liquidity? How may this limitation be overcome?
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The major limitation of the current ratio as a measure of a firm's liquidity is that it does not take into account the quality or composition of current assets and liabilities. It assumes that all current assets can be easily converted into cash within a year and that all current liabilities will be due within a year. However, this may not always be the case. For example, some current assets like inventory or accounts receivable may take longer to convert into cash, while some current liabilities like long-term debt may not be due within a year.
To overcome this limitation, other liquidity ratios can be used in conjunction with the current ratio. These ratios provide a more comprehensive analysis of a firm's liquidity position. Some commonly used liquidity ratios include:
1. Quick Ratio (or Acid-Test Ratio): This ratio considers only the most liquid current assets (cash, marketable securities, and accounts receivable) in relation to current liabilities. It provides a more conservative measure of liquidity by excluding inventory.
2. Cash Ratio: This ratio measures a firm's ability to pay off current liabilities using only cash and cash equivalents. It provides the most conservative measure of liquidity by excluding both inventory and accounts receivable.
3. Operating Cash Flow Ratio: This ratio compares a firm's operating cash flow to its current liabilities. It focuses on the ability of the business to generate cash from its core operations and is not affected by variations in asset quality or composition.
By using these additional liquidity ratios along with the current ratio, analysts and investors can gain a more complete understanding of a firm's liquidity position and make more informed decisions.