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Current Ratio Explained
Current ratio measures a company’s liquidity. It compares a company’s current assets to its current liabilities to determine whether the company has enough assets to pay its bills in the short-term, technically, within a year. Companies with a high current ratio are well positioned to pay their debts in the short-term, while companies with a low current ratio may be at risk of default. Investors use current ratio to assess the financial health of a given company.
This article will help you understand current ratio, how to calculate it, and how you can use it to make more informed investment decisions.
What is Current Ratio?
Current ratio measures whether a company has sufficient assets to cover their short-term debts. It’s calculated by dividing the total value of a company’s current assets by the total value of their current liabilities. Liquidity is an essential component of any financially healthy business. That’s why investors use current ratio as a metric for assessing the financial health of a company.
Importance of current ratio to business
Current ratios vary from industry to industry. You should always assess a company’s current ratio against an industry average. Companies with a higher-than-average current ratio may be financially healthier than their competitors. However, while a high current ratio means a company can easily pay its debts, it can also be a sign that a company isn’t using its assets efficiently. Companies with a lower-than-average current ratio may be at higher risk of distress or default.
Calculation of Current Ratio
You can calculate a company’s current ratio by dividing its current assets by its current liabilities:
Current ratio = current assets / current liabilities.
What’s counted as an asset, or a liability, can vary between companies and different industries.
However, current assets typically include cash, short-term investments, pre-paid expenses, accounts receivables, and inventories.
Current liabilities typically include credit card debt, accounts payable, bank operating credit, the portion of long-term debt expected to be repaid within one year, accrued expenses and taxes payable.
Analysis and Interpretation of Current Ratio
The more assets a company holds, the more capable a company is of paying its obligations. That includes debt repayment, rent, employee salaries, utilities and other fixed expenses. The higher a company’s current ratio is, the less likely it is that cash-flow issues will negatively affect their operations.
Current ratios vary among companies of different sizes and within different industries. Generally, a current ratio of 1 or above means that a company has enough assets to cover its current liabilities. A current ratio of less than 1 means the company is carrying more liabilities than it can pay off and may be more vulnerable to cash-flow issues in the future.
However, a company’s current ratio only measures its financial health at any given time and current ratios are always subject to change.
Use of Current Ratio in Financial Analysis
Considering current ratio when making investment decisions can help you:
Assess a company's short-term liquidity: Companies with a relatively low current ratio may not be able to pay their short-term debts and obligations. This can lead to cash-flow challenges, a reduction in the company’s credit rating, or even bankruptcy.
Compare companies with their peers: Current ratios vary among companies of different sizes and across different industries. It’s always best to compare a company’s current ratio with companies of similar size operating within the same industry. While a company’s current ratio may seem low at first glance, it may be average or high when you compare it to industry averages or its competitors.
Assess a company’s historical performance: Current ratios change frequently. How they change can be an indicator of a company’s financial health. A current ratio that’s been steadily declining over time may indicate the company is experiencing challenges. A current ratio that’s been steadily increasing may indicate that a company’s performance is improving, and the company may be undervalued.
Limitations of Current Ratio
Current ratio should only be used to compare similar companies operating within the same industry. Companies of different sizes and operating within different industries can have markedly different current ratios. If you’re trying to decide between investing in two different companies operating in two different industries, comparing their current ratios really won’t help you decide which company to invest in.
While current ratio gives you a general idea of a company’s liquidity, it’s not very specific. Current ratio considers all a company’s assets – including assets that can’t be easily liquidated. Other more focused liquidity metrics, like the quick ratio, may provide a better assessment of a company’s actual financial health.
Factors that can Influence Current Ratio
Factors influencing current ratios can include:
Industry norms: Current ratios vary across industries. What constitutes a ‘good’ current ratio in one industry may be considered a ‘bad’ current ratio in another. For example, manufacturing and other capital-intensive sectors tend to have lower current ratios than service-based companies.
Seasonal variations: Current ratios can fluctuate throughout the year. For example, businesses with seasonal sales cycles, like retailers, often have higher current ratios during peak shopping seasons than at other times of the year.
Working capital management: Current ratios are influenced by how companies manage their capital. Companies that efficiently manage their working capital by balancing inventory, receivables, and payables may have better current ratios than companies who don’t.
FAQs
What is a good current ratio?
Current ratios vary by industry. What’s considered good in one industry may be not considered good in another. However, generally, a current ratio between 1.2 and 2 can be a sign that a company has enough assets to comfortably cover their debt.
What happens if the current ratio is less than 1?
A current ratio that is less than 1 indicates that a company’s debt is larger than the value of its assets. That means the company doesn’t have enough cash or other assets to pay its short-term debts and other obligations.
What is the difference between the current ratio and the quick ratio (acid test)?
The current ratio and quick ratio are very similar. The only difference is that the quick ratio excludes a company’s inventory when calculating its assets. That can provide a better indication of a company’s liquidity as not every company’s inventory can be liquidated quickly and some companies could potentially hold inventory on hand for several years.
Conclusion
As an investor, it’s important to make informed investment decisions. Current ratio measures a company’s ability to pay its debts and other short-term obligations and can be used to assess the financial health of companies you’re considering investing in. Companies with a relatively high current ratio may be more stable than companies with a relatively low current ratio. Always consider a company’s current ratio and how it compares to its competitors before deciding to invest.
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