The current ratio is an essential financial matric that helps to understand the liquidity structure of the business. It’s especially helpful for the businesses lenders that assessability of the business to repay their dues.
Retail is an industry that is expected to generate cash on a day-to-day basis, and it’s easy for lenders to get collateral over the future cash flow of the retail business.
In the retail industry, the business satisfies the demand of a large number of the consumer base. Retail sales normally generate cash, which is considered the strongest attraction of the retail industry, and managers are least concerned about liquidity management.
Further, the retail business operates throughout vast industrial sectors, from home-based grocery products to medicines and related equipment. The following chart helps to understand the average current ratio of the retail industry.
The numbers have been obtained from the annual report for the year ending 2020 of the respective companies.
|Country||Current assets||Current liability||Current ratio||Inventory||Quick ratio|
|Walmart Inc.||United States||61,806||77,790||0.795||44,435||0.223|
|Amazon Inc.||United States||132,733||126,385||1.050||23,795||0.862|
|Tesco plc||United Kingdom||10,807||5,190||2.082||2,069||1.684|
|The Kroger company||United States||12,503||15,366||0.814||8,436||0.265|
|Ali-baba group plc||China||643,360||377,358||1.705||27,858||1.631|
|Wal green boots alliance||United States||18,073||27,070||0.668||9,451||0.319|
The average current ratio of the industry is 1.186, which is more than one. Hence, the industry seems to be overall liquid. Further, there is significant inventory in the balance sheet of Walmart Inc, the Kroger Company, and the Walgreen boots alliance.
The significance of the inventory leads to the difference between the current ratio and the quick ratio of these companies.
However, there are three companies in our sample that have a current ratio below one. So, we need to understand the working mechanism of the formula, input components of the formula, and other operational details.
The working mechanism of the formula
The current ratio is calculated by comparing the current assets of the business with current liability. If the business’s current assets are more than a current liability, the current ratio is less than one and vice versa. Following is the formula for the current ratio.
Current ratio = Current Assets / Current Liabilities
Similarly, the quick ratio calculation is the same as above, and the only exception is that inventory is deducted from current assets.
Since the average quick ratio of the industry is 30% less than the average current ratio. So, the business model of the sector contains inventory in their financial record.
The business model of the retail industry
The business model of the traditional retail industry is to purchase inventory from suppliers on credit/cash and display it to the customers. The customers are expected to be end consumers buying in line with their needs.
So, the level of inventory is expected to be higher. However, there are certain risks due to higher inventory, including but not limited to the risk of theft, obsolesce, fraud, expiry, and higher cost of holding, etc.
Maintaining a higher inventory level may require financing via payable as suppliers may not be reluctant because of the inventory collateral. Further, the suppliers of the retail business can be small businesses to big brands.
Industry-specific analysis of current asset formula components
The main components of the current assets include cash balances and inventory. Both of these balances seem to arise on account of the business model of the retail industry.
The balance for cash and cash equivalents are higher as these companies directly collect cash from the consumer, and there is no other business in between.
Second, the main component of the current assets in the retail industry is inventory balance. These companies need to ensure sufficient stock is available to meet the demand of the consumers.
Although, there is some risk of obsolesce as some of the inventory items may be slow-moving and lead to expense in the financial statement. Further, the risk of expiry is also prominent if the inventory level of the business is higher.
The denominator of the current asset formula contains current liability. The business-specific items of the current liability in the retail industry are operational payable balance to the suppliers.
Liquidity of retail industry and COVID-19
Due to the recent pandemic of COVID-19, there has been an adverse impact on the liquidity status of the retail industry.
Especially, the closure of the stores had a significant effect on the profitability and liquidity of the sector; this impact was mainly due to a reduction in the volume of transactions.
To recover the sales, there was a race of discounts on the products. However, a significant concern of the discount is that excess discount may impact profitability and the adverse impact on the brand value in the long term.
The second major problem caused by closure was the stuck of funds in the inventory. We have already identified that traditional retail stores usually have a higher stock level to meet the demands of the consumers.
Cash is the lifeline for any business to survive, and tied-up capital/low liquidity can be lethal. However, internal and external measures to cut the capital expenditure, loan restructuring, Government based financing, and other measures to stop the drain of cash seem to be a lifeline for the retail industry.
However, the positive side of the pandemic in the retail industry is a significant increase in online sales. Even after things get to normal, online retail sales seem to remain higher, which offers numerous benefits in terms of reduced cost of stockholding and favorable impact on the working capital management.
The business model of the retail industry supports a higher current ratio. This is because the current assets of retail companies are expected to be higher on account of consumer demand.
Another significant component of the current asset is cash balance; the higher cash balance is that cash is collected on a day-to-day basis, and there is no other business in between to hold the cash.
Further, the lenders of the retail industry are not much concerned about liquidity/repayment as they can get collateral on the business’s future revenue.
In addition to this, the average current ratio of the retail industry is more than one, which means the industry seems to be attractive for the lenders and investors with perspective to the liquidity.
On the other hand, there is a significant difference in the quick ratio and current ratios. That’s due to the higher level of inventory required in the business model of the retail industry.
Due to the higher inventory level, the closure of the stores during the pandemic led to a stuck of working capital. This impact led to a compromise in the profitability and liquidity of the industry during an unprecedented period.
Frequently asked question
Why is an excessive higher current ratio bad for the retail industry?
An excessive higher ratio indicates that the business does not have a feasible investment opportunity. In simple words, if the business has significant liquid resources, it might signal that management cannot find some feasible investment opportunity.
Why retail industry has a higher current ratio?
The business model of the retail industry supports higher current assets by an increased level of cash and inventory balance. The increased proportion of the current assets leads to a decrease in the current ratio.
What’s the importance of liquidity in the financial analysis of the business?
The liquidity of any business is connected with the cash flow needs of the business. As we understand, cash management is an essential aspect of a successful business run.
Further, a large number of the stakeholders like suppliers, investors, and Government are concerned about the cash status of the business due to their stake of collection.
Is a higher current ratio desirable from an investor’s perspective?
From an investor perspective, a higher current ratio is desirable because it indicates the availability of the higher liquid resources and the enhanced ability of the business to pay off its return.