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The current ratio is a financial ratio that demonstrates a company’s ability to meet short-term obligations and liquidity
In this article, we’re going to analyse a financial ratio called the current ratio, understand what it means, get to know its components, understand the formula, and explore what it means to have a low or high current ratio as per a company’s balance sheet.
Understanding the meaning of current ratio
The current ratio, also known as the working capital ratio or the current asset ratio, is a financial tool that compares a company’s current assets to its current liabilities.
Simply put, it measures how well a company can use its readily available resources (current assets) to settle its short-term debts (current liabilities) that are due within one year or the normal operating cycle, whichever is longer.
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The components of current ratio
The current ratio is derived by using current assets and current liabilities, both of which can be found on the company balance sheet.
However, both these components are actually very comprehensive, encompassing several line items within themselves.
Current assets
Cash and equivalents: This includes readily available cash, checking account balances, and highly liquid investments that can be easily converted to cash without significant loss in value.
Marketable securities: These are short-term investments that can be quickly sold in the market to generate cash. These could be stocks, bonds, and mutual funds with high liquidity.
Accounts receivable: This represents the money other people owe to the company. These could be its customers for goods or services sold on credit. While technically an asset, collecting these receivables can sometimes involve delays.
Inventory: This includes the raw materials, work-in-progress, and finished goods that a company holds for sale.
Prepaid expenses: These are expenses a company has already paid for but hasn’t yet consumed. Examples include prepaid rent, insurance, or supplies.
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Current liabilities
Current liabilities represent a company’s short-term financial obligations that are due within one year or the operating cycle. These typically include:
- Accounts payable: This represents the money the company owes to its suppliers for goods or services purchased on credit.
- Short-term debt: This includes loans, lines of credit, and other borrowings that need to be repaid within a year.
- Accrued expenses: These are expenses a company has incurred but hasn’t yet paid for. Examples include accrued salaries, wages, or interest.
- Taxes payable: This includes upcoming tax payments owed to the government.
- Current portion of long-term debt: This represents the portion of a long-term loan that is due for repayment within one year. These could include both interest and principal paybacks.
The formula for current ratio
The current ratio is calculated using a straightforward formula:
Current Ratio = Current Assets / Current Liabilities
Understanding a high or low current ratio
A higher current ratio generally signifies a company’s strong short-term financial health. It suggests that the company has ample resources to meet its upcoming obligations and potentially absorb unexpected financial setbacks. However, there’s no single ideal current ratio that applies universally.
The optimal ratio can vary depending on the industry, business model, and growth stage of the company.
Limitations of the current ratio
The current ratio, just like any other financial metric, is not perfect. The quality of the inputs in the ratio matter when analysing a company for investment purposes.
Analysts believe that not all current assets are created equal. Inventory, for instance, that takes a long time to sell might be less valuable than readily available cash to the company.
Additionally, the current ratio only considers the liabilities that are listed on the company’s balance sheet. Other liabilities like unforeseen contingencies or hidden liabilities might affect the company’s ability to meet its obligations and demonstrate a false sense of security to investors.
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Frequently Asked Questions
Both measure liquidity, but the quick ratio (current assets minus inventory / current liabilities) excludes inventory due to its potential for slower conversion to cash. It provides a stricter test of a company’s ability to meet short-term obligations using highly liquid assets.
Retail companies typically hold higher inventory levels, leading to potentially lower current ratios compared to service-based businesses with fewer current assets.
A consistently low current ratio might raise concerns about a company’s reliance on debt. Investors may view this as a risk factor, which might impact the company’s ability to secure more financing in the future.
Several resources offer industry-specific financial ratios. You can access them through online financial databases, investment research reports, or industry publications. These benchmarks provide a reference point for comparing a company’s current ratio with its industry peers.
Not necessarily. Companies in high-growth phases often use debt to fuel expansion. However, a consistently low current ratio combined with increasing debt levels can raise red flags for investors. This scenario suggests the company might struggle to meet its short-term obligations if its revenue growth slows or it encounters unexpected financial difficulties.