Understand and Calculate the Current Ratio
The Current Ratio, a test of a company’s financial strength, is primarily used as an indication of a company’s ability to pay off its short-term liabilities with its short-term assets- cash, inventory and receivables. The higher the current ratio, the more able the company is to pay these obligations. Lower values in the current ratio indicate that the company may have problems paying its short-term debts.
The current ratio offers investors a sense of the efficiency of the company’s operations and its ability to turn convert product into cash. Companies that have long receivables cycles or long inventory turnover can develop liquidity issues.
How to Calulate the Current Ratio
The current ratio is calculated as follows:
Current Ratio = Current assets / Current liabilities
Current assets include only those assets that could be converted to cash quickly. In addition to cash, current assets include bonds, inventory and accounts receivable. Current liabilities are debts that will come due in the near-term, typically in the next year.
The downside of this ratio is that is doesn’t account for the ability to liquidate inventory. Because of this, the current ratio tends to overstate the short term liquidity.
To retrieve the data you will need for the calculation, go to Yahoo! Finance and enter the company stock symbol in the Get Quotes window. Click on the Balance Sheet on the lower left-hand side under Financials.
Determining Financial Strength
If the current assets of a company are more than twice its current liabilities, the company is generally considered to have good short-term financial strength. If, on the other hand, its current liabilities are greater than its current assets, then the company may have issues in meeting its short-term obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came immediately due at that point. In that situation, the company should consider liquidating some its inventory or refinancing short-term debt with long-term debt. The company might even consider selling some of its fixed assets in order to meet it obligations.
Extremely high ratio’s can indicate unnecessary accumulation of funds, excessive inventory levels or bad financial management.
Because business operations differ in each industry, it is always more useful to compare companies within the same industry.
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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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