Current Ratio
How to use current ratio
A current ratio of 1.5 means the company has $1.5 in assets for each $1 in short term liabilities (debts).
- Higher is better
- Above 1.5 is considered healthy (always compare to industry mean).
- Can be very different between industries
- Can be used to compare companies
Why do investors use current ratio in their analysis
Shows if the company can pay of short term debts if needed. A company that can't pay off it's short term debts might get in trouble if they have to pay off their short term debts for whatever reason. For example, markets can change due to global events like covid-19 or the war in Ukraine versus Russia. Because debts are always taken based on future income, it might become troublesome for the company if something happens in the market that will cause sales to plummet.
The three steps every investor should look at:
- What is the current current Ratio?
- How does it compare to the industry?
- What is the trend?
Things to be aware of
- Only compare with other companies in the same industry.
- Might be deluded.
- Not all assets can always be quickly sold.
- Can be manipulated by increasing or decreasing the assets and/or liabilities.
How to calculate current ratio
Real life example
A real life example of Tesla. You need the following data to determine operating ratio:
- Current ratio = current assets / current liabilities
- $31,222,000 / $21,821,000 = 1.43
Tesla has $1.43 for each $1 in liabilities
The current ratio measures if the company is able to pay short-term debts (obligations). Short term in this context means all debt obligations that are about to expire within one year. The current ratio incorporates current liabilities and current assets. Current assets are all the assets a company has that are expected to be consumed or sold within standard business operations. You can find the current assets in the balance sheet. They consist of:
- Inventory
- Accounts receivable
- Marketable securities
- Prepaid expenses
- Cash
- Cash equivalents
- liquid assets
The current liabilities are short term obligations that are due within one year. These consist of:
- Short term debts
- Dividends
- Income taxes
- Short-term debts
- Accounts payable
- Interest payments
The result shows an investor if the company is able to pay all its short-term debts if they were due all at once. When the result of the above formula is below 1, then the company does not have enough capital after selling all its assets to pay all short-term debts. If the ratio drops far below 1 that might indicate is or will be in financial trouble anytime soon.
Although this gives an investor some clues, the current ratio may also be deluded. Because owning assets does not mean the company can easily sell them. Also, Accounts receivable may be quite old (they will probably never pay) which deludes the current ratio. As with all ratios, you should only compare them between the same industries and companies.
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