The current ratio is an important measure of the short-term liquidity of a company. The ratio measures the company’s ability to pay its bills in the short term, in particular over the next twelve months.
To do this, it compares a firm’s current assets to current liabilities. In effect, it indicates the extent to which a company’s current assets can cover its current liabilities. Simply put, the current ratio lets you know if a company can keep its lights on.
Current assets are defined as company cash and assets that can be easily converted to cash within a year.
- Cash equivalents
- Accounts receivable
- Marketable securities
Current liabilities are defined as company obligations that must be paid in full within a year.
- Accounts payable
- Taxes payable
- As well as the current portion of long-term debt
With that, the more current assets a company has, the better they can handle their short term payable obligations.
Knowing the current ratio is vital to your decision making process. In particular because it is an important tool in assessing the viability of a company’s short term ability to operate.
Current Ratio Formula
With the current ratio, you are comparing current assets to current liabilities. So to calculate the ratio, you simply divide the company’s current assets by the company’s current liabilities.
You are looking at a company that has the following current assets and current liabilities on its balance sheet:
Current Assets –
- Cash = $100 million
- Accounts Receivable = $50 million
- Inventory = $155 million
- Marketable Securities = $ 25 million
Current Liabilities –
- Accounts Payable = $120 million
- Wages Payable = $20 million
- Short-term Debt = $25 million
First, total current assets = 100 + 50 + 155 + 25 = $330 million
Then find the total current liabilities = 120 + 20 + 25 = $165 million
Current Ratio = current assets / current liabilities = 330 million / 165 million = 2
Looking at this company, you will calculate a current ratio of 2. In your analysis, this shows that the company can cover the current liabilities twice with the total current assets. With a ratio over 1, this lends to a solid short term view of financial well being of this company. However if it gets too high, the company may not be using its assets very effectively. So be sure to always compare these ratios within industry averages as well.
Finding the current assets and liabilities
In order to find the current assets and liabilities, you will look at the balance sheet. Current and long term assets as well as current and long term liabilities are separated on the balance sheet.
The purpose of this separation is to list them in order of liquidity. For this reason, you will see current assets and liabilities listed above long term assets and liabilities. Which allows for the calculation of a number of other ratios that need different information based on liquidity levels.
With the current ratio, you can get a view of the short term liquidity of a company.
If the current assets exceed current liabilities the ratio will be greater than 1. This may signify a level of financial health.
If the liabilities exceed the assets the ratio will be less than 1. This may in turn be a sign that the company could have a hard time meeting its short term obligations.
Analysis using the Current Ratio
When using the current ratio as a tool, you should always be comparing it within in the same industry. As well you be looking at the trend of the ratio over time.
With the different financial structures between industries, the ratio won’t mean much unless compared to similar companies.
You want to see a current ratio that is in line with or slightly higher than the industry average. A company with a lower ratio than the industry average may indicate it has a higher risk of default.
Generally speaking, you will want to see a ratio of at least 1. As this signifies a company’s current assets can at least meet the short term obligations. And a ratio over 1 will give even greater cushion to the company’s obligations. Taking some pressure off.
For a creditor, a high current ratio is obviously better than a low ratio. This is because a company with a higher ratio has a greater ability to pay its bills.
As a current ratio that is higher than the industry average is generally a good thing. It may also suggest the inefficient use of company resources. So watch out for a ratio that is a lot higher as opposed to slightly higher. Then look into the reasons it is so much higher in order to find out if it is a good or bad thing.
And a lower ratio than the industry average is then, of course, something to look for as it could entail liquidity problems for the company. Always pay attention to this and dive a little deeper into the reasons before investing.
When analyzing the current ratio, you will also want to look at its changes over a period of time. Look at what the trend is to see if it is stable, up or down. An increasing ratio can improve liquidity. While a decreasing ratio may point to a deteriorating situation.
Limitations of the Current Ratio
Financial structures differ substantially between industries. So current ratios are really only useful when comparing companies within the same industry.
- You may be looking at a company in the manufacturing industry with a ratio of 1 and a company in the construction industry with a ratio of 1. If the industry average for manufacturing is 2.14 and the average for construction is .97. Then a ratio of 1 is good for the construction company, but not so much for the manufacturing company. For this reason, don’t compare them to each other. Compare them to their own industry and other like companies.
Current assets include many assets that may not be easily converted to cash, such as inventory. If the current assets include a large proportion of inventory, the short term liquidity may not be as solid as it seems, since inventory can be difficult to liquidate.
- Two companies both have a current ratio of 1. At first glance these companies look to have the same liquidity value. However, depending on the makeup of current assets, they can be in quite different situations.
- If company A has a lot more inventory on the books which is harder to liquidate. And company B has more cash which is the most liquid asset. Then company A could have a harder time converting its assets to cover liabilities than company B. So even with the same ratio, it is always useful for you to actually look at the levels of each asset and liability when comparing two companies.
Whether or not a company can keep its lights on depends on its ability to meet its short term obligations. You can use the current ratio to get a good idea of this, due to the fact that it compares a firm’s current assets to current liabilities.
The more current assets a company has, the better it can handle its short term obligations. Preferably you want to see a ratio of 1 or higher. In effect letting you know the company can cover its liabilities and continue to operate for the next year.
When using the current ratio to compare companies, always compare companies within the same industry. Different financial structures within industries will make it otherwise meaningless.
In conclusion, this is a great ratio to use in your financial statement analysis. Of course there are many other ratios and ways of analyzing financial statements and the financial health of a company. Using them together will give you the best view. So take time to learn them and you will be well equipped to understand and assess the financial health of a company.