The current ratio measures a companies ability to pay back it's short term obligations which is important in determining the companies financial health.
The Current Ratio is calculated by dividing a companies Current Assets by it's Current Liabilities.
Current Ratio = Current Assets / Current Liabilities
where Current Assets include Cash, Marketable Securities, Accounts Receivable, Inventory etc.
and Current Liabilities usually include Short Term Debt, Accounts Payable, Salaries and Wages Payable, Accrued Expenses etc.
Since companies are required by GAAP to classify assets and liabilities into current and non-current on their balance sheets it is easy to find the Current Assets and Current Liabilities listed in the company Balance Sheet.
The Ratio is stated in a Numeric format (1,2,3,4 etc.) rather than in a decimal format (0.1, 0.2, 0.3, 0.4).
Overall, a higher Current Ratio is more favorable then a lower one because a higher ratio means that a company has a higher amount of Current Assets to pay off its Current Liabilities should the need arise.
A Current Ratio of 2 is usually considered healthy because it means that a companies current assets are 2 times the company liabilities, though acceptable current ratios vary depending on the Industry.
A Current Ratio of less than 1 is usually a red flag since the company does not have enough Current Assets to match its Current Liabilities and should be investigated further.
It is wise to compare the Current Ratio with previous years to see if company liquidity is improving or deteriorating.
Also, comparing the Current Ratio with other companies in the Industry can magnify the usefulness of the Ratio and give the user deeper insights into the liquidity of the company versus it's peers.
Example 1 : A Company with $10 Million in Current Assets and $5 Million in Current Liabilities would have a current ratio of 2 times ($10Million/$5Million).
This indicates that the company has 2 times more Current Assets then Current Liabilities.
Example 2 : A Company with $25,000 in Current Assets and $100,000 in Current Liabilities has a Current Ratio of 0.25 times ($25,000/$100,000).
This indicates that the company has Current Assets to pay off only 25% of it's Current Liabilities
1. The Current Ratio calculation assumes that all the Current Assets can be liquidated should the need arise to pay off the company Liabilities which is not realistic in practice since a company always needs some current assets to continue its operations.
2. The Ratio also includes ALL Current Assets that may not be easily liquidated. For example, a company may have obsolete inventory or overdue receivables which the company is having a tough time collecting.
To mitigate the effect of this, beyond just looking at the current ratio, an analyst should also look at the composition and quality of the company’s current assets.
The current ratio is just one of many financial indicators that potential investors and creditors will need to analyze.
A more meaningful liquidity analysis can be conducted by using the Current Ratio in conjunction with other Liquidity Ratios such as Quick Ratio, Cash Ratio & Cash Conversion Cycle.
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