Financial ratios are important for investors who are looking to pick the right stocks for their portfolio. They speak a lot about the performance of the company and the stability of the business. One of the most important ratios in the financial statements is the current ratio.
What is the current ratio?
The current ratio is used to access the liquidity of a company in the short term. The liquidity is assessed keeping the available assets and outstanding liabilities at the forefront. It shows the ability of a company to generate cash in order to pay off the debt once they become due. It is used across the world to measure the financial strength of a company.
What is a good ratio?
The range of ideal the ratio varies based on the type of industry you operate in. However, a ratio ranging from 1.5 to 3 is very healthy. A current ratio that is lower than 1 is not ideal and it shows that the company has liquidity problems. The company may not face a crisis immediately but there could be problems in the future. A ratio of more than 3 shows that the company is not making the most of its current assets or not handling the working capital properly. All other things being equal, creditors consider a high ratio to be better than a low current ratio, because a high ratio means that the company is more likely to meet its liabilities which are due over the next 12 months.
How to calculate the current ratio?
You only need two details to calculate the current ratio. The details are reported in the annual and quarterly financial results of a company. The formula to calculate the current ratio is:
Current Ratio= Current Assets / Current Liabilities
Current Assets= The current assets are found on the balance sheet of the company and it shows the value of all the assets that can be converted in a year. All companies own current assets. Its examples include cash and bank, inventory, debtors, prepaid expenses, marketable securities, accounts receivable, and other liquid assets. Do not include in the numerator any excessively old receivables that are not likely to be paid, such as anything over 90 days old.
Current Liabilities= The current liabilities of a company include obligations that are due in a year and they are shown on the balance sheet. Some examples include short term debt, accounts payable, current portion of long term debt, and accrued liabilities.
Example of calculating the current ratio
Let us look at an example to understand the ratio better. Assume that a company ABC has current assets of $169 billion and current liabilities of $58 billion. Its current ratio will be 169/58 = $2.91. A ratio above 2 is considered to be superior and financially healthy. It shows that the company has the ability to pay off its obligations.
Using the ratio
The ratio is used by all the readers of financial statements. It gives insight into the financial health of the company and is an important ratio that is considered by investors. The best way to use the ratio is to compare it with competitor companies in the industry. You should not use the ratio in isolation because it will not give you adequate information about the business.
Before making an investment decision, it is best to compare the current ratio between companies and then make a decision. A high ratio shows that the company is stable and your money is safe. A low ratio shows that the company has high liability and fewer assets to pay for the same. It is also used by the management to make business decisions like an investment in inventory and making prepayment of expenses.
Limitations of the ratio
- The current ratio does not focus on the breakup of the quality of the assets. Each current asset has different interpretations and serves different purposes but the importance and quality of each are not considered.
- When the ratio is used in isolation, it means nothing for the reader. It will not give any insights into the profitability of the product.
- It is easy to manipulate the ratio. When management increases the current assets and current liabilities in an equal amount, the ratio will decline and an equal decrease in the current assets and current liabilities will lead to an increase in the ratio.
The ratio is one of the most important ratios in financial statements and all companies use the ratio. You can easily find the necessary information on the balance sheet and calculate the ratio yourself. The ratio will help make the right decisions with regard to borrowing and investment. The ratio can also be found in the financial statements. Comparing the ratio with organizations in a particular industry gives insights into the performance of a company and its financial health.