Comment on the following: A firm having high current ratio may not necessarily be treated as being favourably placed as regards payment of its current liabilities.

Traditionally, it has been believed that liquidity is proportional to the level of current assets. A firm having a high current ratio is treated as favorably placed as regards payment of its current liabilities. This is a myth since the holding of current assets is always in proportion to the turnover. If level of current assets is rising disproportionately to the turnover, then notwithstanding the high current ratio, the situation has the following implications: The age of current assets is increasing which tells upon their quality. As the current assets, particularly inventory and receivables, get older the chances of their easy and complete conversion into cash recede. Once this happens, there is every possibility of the operating cycle cracking. The firm is paying a huge cost for the higher build up of current assets. This cost consists of: The amount spent towards raw materials and intermediate inputs The cost incurred towards storing and maintaining the inventory The interest cost for obtaining finance against these current assets The cost of obsolescence associated with holding inventory for longer periods and The cost of expected default on receivables as reflected in charge to Profit and loss account towards bad debts.