What is Current Ratio?

Fundamentals ·

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In fundamental analysis of a company the current ratio plays an important role by expressing the liquidity of the firm in just one number. This is a basic financial indicator in accounting which is easy to calculate.

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Today we'll have look at this ratio and explain how it can be useful for an investor.

How To Calculate The Current Ratio?

The formula for the current ratio is quite simple:

\begin{align} CR = \frac{CA}{CL} \end{align}

Where:

  • CR: Current Ratio
  • СA: Current Assets
  • CL: Current Liabilities

“Current” in this case means assets or liabilities that can be easily exchanged for the real money (cash), this is another definition of liquidity, so those assets and liabilities can be called liquid.

Examples of current assets:

  • Cash in different currencies and its equivalents
  • Market securities (shares, stocks, bonds, etc.)
  • Accounts receivable (money to be received relatively soon and without issues)

Sometimes currents assets can be referred to current accounts.

The opposite of it is the long-term assets: property and land, equipment, brand value (copyright), etc.

Examples of current liabilities:

  • Accounts payable
  • Sales and income taxes payable
  • Interest payable
  • Customer deposits
  • Dividends declared
  • Short-term loans (debts)

Understanding The Current Ratio

This ratio is an indicator of a firm's liquidity, it shows the proportion of the company's easily accessible assets relative to its short-term financial obligations.

Let's imagine a small company, a convenience store, which has to pay its suppliers $100,000 for the goods received (which are not sold yet). That's the current liability which has to be covered with cash soon. A store is a good example because the current ratio is often used to analyze retail business, which has a specific operating model with a high of turnover.

If this store has $50,000 cash and no other current assets, the ratio would be 0.5

\begin{align} \frac{100,000}{50,000} = 0.5 \end{align}

Is that a good number? Well, if a business can't pay everything it owes at a time, it might go bankrupt if of all its suppliers (or debt holders) decide to claim everything at the same time.

Banks have a similar business model and they are required to have a portion of their capital in liquid assets.

The current ratio of 0.5 (50%) is bad for business in general, but it may not be critical in some cases if the owner knows suppliers well and if he has the ability to borrow more in an extreme case.

0.5 and 50% basically means that the business can cover 50% of its financial obligations immediately if needed. For different kinds of industries, a “normal” current ratio would be at different levels.

What Is A Normal Current Ratio?

According to the wellsfargoworks the average current ratios are:

  • Construction: 0.97
  • Manufacturing: 2.14
  • Real Estate: 1.48
  • Wholesale: 1.48
  • Retail: 1.47

The numbers may vary depending on the source but they are more or less the same.

It can be said that the current ratio of 1.5 is OK for most industries, but in some business sectors, it can vary from 1 to 2. The ratio of less than 1 is usually a very bad sign. The current ratio of 1.2 means that the company can cover 120% of its current liabilities with its liquid assets and the ratio of 1.5 indicates that this firm has 50% more current assets than it has soon to pay.

A normal value depends on a turnover cycle of a particular business and how liquid those business operations are.

For instance, we know that in construction everything is usually paid quickly and on time because it is the nature of that business: the cash cycle is fast and that is why the current ratio can be a bit lower.

In the manufacturing industry, the production cycle is usually slow as it involves dealing with complicated relations issues and logistics, therefore a company has to have a high current ratio. If something goes wrong during this long cycle, the company wouldn't be able to recover (most of their assets are expensive equipment and other non-liquid assets).

On the other hand, the IT industry current ratio (as many other classical financial ratios) might not work properly due to its complex nature. For example, Google has a current ratio of 3.96 at the time of publication, which is extremely healthy and high but some small startups in the IT sector may have an extremely low current ratio and that wouldn't necessarily suggest that they are close to bankruptcy. Just keep in mind that the majority of classical financial indicators and ratios were created for businesses that existed for a long time and many IT companies are relatively new.

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