The Current Ratio in Fundamental Analysis

The Current Ratio is one of the standard measures of the financial health of a business. The measure can provide an indication of whether the business will be able to meet its short-term obligations by measuring the level of current assets to cover those liabilities. In other words the current ratio can tell an investor if the company is in a good position to pay its bills over the next year. While most ratio standards vary from industry to industry, a very healthy company is believed to have a current ratio of two. The average current ratio for S&P 500 stocks is currently about 1.65. The great value investor, Benjamin Graham, looked for a current ratio of at least 1.5.

Fundamental Investing and the Balance Sheet

The fundamental analysis of a business is about analyzing company financial statements to assess the health of the company and determine its competitive advantages. In performing due diligence fundamental investors will often extract the financial data the balance sheet provides to conduct ratio analysis. Often, the investor will compare these ratios to the ratios of companies within the same industry and observe how the ratios change over time.

The Importance of the Current Ratio in Assessing Company Financial Health

The formula for the Current Ratio is simply:

Current Ratio = Current Assets / Current Liabilities

The current ratio is falls into the category of liquidity ratios. Each of the ratios in this class is used to determine a company’s ability to pay off its short-term debt obligations and, generally speaking, the higher the ratio the better. Although a very high current ratio can raise concerns as it can suggest that the company is not putting its resources to their best use.

Any company that has a current ratio close to or below one should not be considered for investment unless it is believed to have a significant level of inventories that can be converted to cash very quickly. Even in this case, however, there is significant cause for concern.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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