Investors and analysts always look for information on how likely a company is to pay all outstanding dues and meet short-term financial obligations towards clients or lenders. In short, investors try to gauge a company’s liquidity levels. A liquidity ratio measures a company’s short-term solvency and is a part of fundamental analysis of a company. One of the important liquidity ratios used by stakeholders is the current ratio. It compares the current assets of a company to its current liabilities.
Liquidity is one of the most important factors responsible for the smooth functioning of a business. This ratio specifically tells investors about a company’s ability to maximize its assets on the balance sheet to meet its debt and other payables. Let’s understand the concept of current ratio in further detail.
What is current ratio?
Current ratio is also referred to as the working capital ratio. It measures a company’s ability to repay its short-term debt obligations. Short-term debt is that which is due within one year and has to be repaid using current assets alone. A company must ideally have sufficient assets to repay its debt without requiring fresh capital or diluting its shareholding.
The name of this ratio is so because it estimates only a company’s present assets and liabilities, unlike other liquidity ratios. Current assets are those assets that can be easily liquidated and converted into cash within a short duration, approximately one year. Current assets may include:
- Cash
- Money market instruments
- Accounts receivables (from vendors or customers)
- Mutual fund investments
- Inventory
- Prepaid expenses
Current liabilities include short-term debt or short-term loans payable. These include:
- Accounts payable (to suppliers)
- Outstanding expenses
- Deferred taxes
- Advance receipts from customers
- Declared but yet to be paid dividends
Current ratio formula & calculation
The formula to calculate the current ratio of a company is
Current ratio formula = Current Assets / Current Liabilities
Example using the current ratio
Let us understand the calculation of the current ratio with the help of the below example:
These are financials of Shine enterprises:
Liabilities | Rs. | Assets | Rs. |
Equity Share Capital | 2,52,000 | Land and Building | 1,50,000 |
Reserves and Surplus | 57,500 | Plant and Machinery | 1,00,000 |
12% Debentures | 64,500 | Investments | 50,000 |
Creditors | 1,00,000 | Stock | 79,000 |
Bills Receivables | 7,500 | Debtors | 120,000 |
Accrued Expenses | 17,500 | ||
Total | 4,99,000 | Total | 4,99,000 |
To apply the current ratio formula, we need to arrive at the total current assets and total current liabilities. Calculation of the total current assets and current liabilities is tabled below.
Current assets | Amount | Current Liabilities | Amount |
Stock | 79,000 | Creditors | 1,00,000 |
Debtors | 1,20,000 | Bills receivables | 7,500 |
Accrued Expenses | 17,500 | ||
Total | 1,99,000 | Total | 1,25,000 |
Applying the formula of current ratio, we get:
Current Ratio = 1,99,000 / 1,25,000 = 1.59
Thus, the current ratio of Shine Enterprises is 1.59:1. This implies that the firm has Rs. 1.59 worth of assets to pay back every Re. 1 of liability.
Components of the formula
To calculate the current ratio of a company, users need to understand the components of the above formula. The details of the same are given here.
Current assets
Current assets are the short-term assets of a company that can be easily liquidated. Following are the current assets that form part of any balance sheet.
- Cash
- Money market instruments
- Accounts receivables (from vendors or customers)
- Mutual fund investments
- Inventory
- Prepaid expenses
Current liabilities
Current liabilities are short-term liabilities
- Accounts payable (to suppliers)
- Short-term debts
- Deferred taxes
- Advance receipts from customers
- Declared but yet to be paid dividends
- Miscellaneous expenses (outstanding fee, accrued taxes, ammortized expenses, etc.)
What is an ideal current ratio?
After calculating the current ratio, one must know how to interpret it, especially for investment decisions. Here are some basic guidelines on current ratio interpretation:
- Current ratio > 1 is considered good
This means that the company’s current assets are more than its current liabilities. Therefore, it will have strong cash flows and may pose minimum credit risk.
- Current Ratio < 1 is considered a red flag for investors
This is when a company’s current assets are less as compared to its current liabilities. Such companies may need to raise additional funds or liquidate long-term assets for paying off loans. These companies tend to carry higher credit risk.
- Current Ratio = 1
When a company’s assets and liabilities are the same, its current ratio will be 1. This indicates that the company has only as many assets as can repay its loans. With a small decrease in its cash flow, the company may easily face credit defaults.
Therefore, investors tend to prefer companies with a current ratio that is more than one. Generally, the higher the current ratio, the better position it is considered to be in. However, a current ratio beyond three could mean that the company has an abundance of cash and it is not being used productively. An ideal current ratio is something between one and three.
Why is the current ratio important?
Current ratio is considered by creditors while evaluating a company’s credit status before offering short-term debts. This ratio also gives insight into a company’s operating cycle. It reflects a company’s ability to liquidate its assets for paying off its short-term liabilities.
What are the limitations of the current ratio?
Here are some of the limitations of current ratio that should be considered before using it for company evaluation:
- The ratio only talks about the quantity of assets and not necessarily the quality of assets held by a company.
- It is possible to manipulate a current ratio through overvaluation of current assets.
- Current ratio does not tell whether a company is receiving timely payments from customers. For instance, a company may have a high current ratio but its customers could be delaying payments.
- Many companies may neglect several liabilities to present a good current ratio.
Conclusion
While the current ratio is important for analyzing a company’s financial health, it is not the only determining factor that investors should consider. A company that has a current ratio of 2 or more may not necessarily be worth investing in. Investors should bear in mind that a current ratio does not always represent a company’s liquidity or solvency. There are various other factors that equally determine a company’s financial health.
In the end, it is important to keep in mind that no one financial parameter defines a company’s investment worth. To gauge a company’s full potential, investors and stakeholders must look at all possible factors and from all angles.
FAQs
The quick ratio is a measurement of a company’s capacity to pay towards its current liabilities without selling its inventory or obtaining additional financing. The higher the quick ratio, the better a company’s liquidity and overall financial health.
Current ratio considers all of a company’s current assets, while a quick ratio includes only those current assets that can be liquidated within 90 days.
Current ratio and quick ratio are the best measures of a company’s liquidity. Quick ratio is the conservative approach of the two since it doesn’t consider inventories and current liabilities while estimating the company’s liquidity.
Liquidity is the ability of a company to convert its asset easily into cash and without any losses against the market price. It is an important factor for learning how easily a company can manage to pay off its short-term liabilities and debts.
Stock investors generally look at the company’s EPS or earnings per share, Price to earnings ratio, plough back and reserves while selecting the right stock to buy.
