What is the Current Ratio?
The current ratio can be termed as the efficiency and liquidity ratio that measures an enterprise’s capacity to pay off its short-term obligations using its current assets. It is a fundamental assessment of liquidity owing to the fact that interim liabilities are due within the following year.
Financial liquidity refers to a company’s ability to access cash quickly, and it’s ability to meet its obligations like debt, payables, and tax bills.
This implies that a firm has a restricted duration to gather finances to offset these liabilities. It is important to note that current assets, for instance, marketable securities, money, and cash equivalents can, in the short term, be easily converted into cash.
This suggests that corporations with massive quantities of current assets can increase their capability to pay current liabilities when they are outstanding without selling long-term assets that generate revenue.
Current Ratio Formula
According to analysts, a corporation’s current assets are compared to its current liabilities. A firm’s balance sheet usually lists current assets like cash, inventory, accounts receivable, as well as other assets that are projected to be liquidated in less than a year.
On the other hand, current liabilities entail taxes payable, wages, accounts payable, and the current fraction of long-term dues.
Formula: Current assets / current liabilities
For example, a firm with current assets amounting to $10 million and current liabilities of $5 million can have a current ratio of 2.0.
Note: In terms of current ratio, 1.0 or above indicates that the company is well-placed to cover its short-term or current liabilities. Therefore, a current ratio that is lower than 1.0 can hint trouble in the event that the organization incurs a financial problem.
Bonus Tip: This ratio is described as ‘current’ since, unlike several other liquidity ratios, it includes all current liabilities and assets. In addition, it is also referred to as the working capital ratio. A current ratio that corresponds to the industry average or considerably higher is usually deemed acceptable.
On the contrary, a lower one may be a sign of a higher risk of non-payment or distress. In the same manner, if an organization has an extremely high ratio when judged against those in its category, it reveals that the administration may not be utilizing their assets productively.
Current Ratio Example
Let’s look at an example in Apple’s balance sheet.
We can see that Apple’s total current assets are $162B, and it’s total current liabilities are $106B. We can simply divide 162 / 106 and get the current ratio of 1.52. According to the rough rule of thumb, Apple is pretty financially healthy.
It’s useful to compare a company’s current ratio to its historical ratio, to see where the trend is going. In the case of Apple, we can see that it’s current ratio has been trending down for the last decade or so.
This type of analysis can also be deceiving though, as Apple has a very strong cash balance and the ability to negotiate favorable financing terms due to their creditworthiness as the second largest company in the world (at the time of writing).
Current Ratio and Time
Changes affect the current ratio’s propensity to be bad or good. An establishment that appears to have a ratio that is acceptable could be inclined towards a scenario where it will battle to offset its bills.
Notably, the pattern of the current ratio across time would be anticipated to have a negative effect on the company’s worth. In contrast, a firm that seems to be straining in the present could be progressing well towards an enriched ratio.
For that reason, an improving ratio can be an indicator of a chance to invest in an underrated stock in an enterprise’s turnaround.
Where the Current Ratio Comes up Short
We refer to the current ratio as ‘quick and dirty’ because there’s no context. Each industry has different working capital requirements. Comparing Exxon’s current ratio to Apple’s current ratio would be an apples to oranges comparison, requiring more analysis than a simple ratio. The ratio is quite useful when comparing the liquidity of companies within the same industry.
You’ll often hear that a current ratio greater than 1 is generally considered financially healthy, while those below 1 are in danger of being forced to make suboptimal financing decisions. This is generally true, but again, requires context. The construction industry, for example, has an average current ratio of 0.97.
Current assets are assets that are cash, or can be turned into cash within one year. Things like accounts receivable, inventory, and marketable securities. In the event that a company is hit with a huge, unexpected bill, these assets can be turned into cash within a year without a significant impact on the price received.
Current liabilities are obligations due within a year. Things like wages payable, accounts payable, tax bills, and loans due within a year.
To calculate a company’s current ratio, all you need are two line items from the balance sheet: current assets and current liabilities. You simply divide current assets by the current liabilities
When exploring the current ratio, it is pivotal for investors to be aware that it does not entail everything about a firm’s liquidity. Additionally, they should comprehend the kinds of current assets the corporation has and how swiftly they can be turned into cash to match current liabilities.
For instance, how fast can an enterprise collect all its unsettled accounts receivables? From an analyst’s viewpoint, it is essential to look at the corporation’s day sales outstanding. This is a measure of the duration it takes the organization to obtain payment after a sale.
If a firm has to sell its fixed assets as compensation for its current liabilities, then it implies that the corporation is not making adequate room for operations to back activities. Simply put, the business is exhausting money. In some cases, this is the outcome of ineffective collections linked to accounts receivable.
The primary use of the current ratio is as a big picture look at a company’s financial liquidity–a big picture which can be misleading. When making investing decisions, it should never be used in lieu of rigorous financial analysis
Lack of Asset Discrimination
A prime limitation of the current ratio is that it doesn’t discriminate between different types of current assets or liabilities. A million dollars of cash and a million dollars in inventory is treated the same in the calculation.
Some companies’ inventories are either illiquid or don’t have much of a secondary market. This is especially risky in the consumer discretionary sector, where brands and trends rule.
To illustrate this, let’s consider a hypothetical manufacturer of roller skates during the skating boom of the 1990s. In an enthusiast market like skating, brand is huge. If the company doesn’t have a strong brand, there won’t be a strong secondary market on which to liquidate their inventory. Further, if the trend began to fade, they could be sitting on near-worthless inventory.
For those looking for ways to more rigorously compare current assets and liabilities, consider using a multiples approach as used by Ben Graham in Security Analysis.
In Graham’s calculation of net net working capital, he applied a percentage multiplier on current assets. As you can see in the table below, he valued inventories at roughly 66% to account for the possibility of illiquid inventory. You still might have to tweak this based on the sector.
It’s crucial to analyze the quality of current assets. Liquidating a bunch of iPhones is easier than liquidating roller skates. Marketable securities have different levels of liquidity. Companies have different abilities to inspect the creditworthiness of their customers.
Applying the Current Ratio in Momentum Trading
Momentum traders, which is most of our audience, might ask why the current ratio is useful? Well, the current ratio can clue you into when a company might have to raise capital. In the micro and small cap, where many momentum traders reside, these things are generally easier to sniff out and affect the stock price more dramatically.
Cash is the lifeblood of a business. It doesn’t matter how valuable a company’s brand is, or how quickly their sales are growing if they don’t have the cash to continue operations as usual. The current ratio is an easy way to sniff out cash problems at a business, especially microcaps which have a tendency to run.
When companies have a current ratio well below 1 and trending downward, along with their cash balance dwindling, they have a few choices: raise capital or liquidate. The vast majority of them choose to raise capital, especially the ‘momo’ microcaps who regularly disregard long-term shareholder value.
Such companies tend to raise capital through equity, rather than debt, diluting their shareholders in the process. It should go without saying that shareholders don’t like being diluted, and equity offerings are usually followed by sharp drops in the stock price.
Knowing the financial health of tickers on your radar can clue you in on upcoming catalysts before the rest of traders pile into the trade based on price action.
The current ratio is useful when utilized the way it’s meant to be: as a quick and rough gauge of a company’s financial liquidity. As mentioned, there are plenty of limitations due to it’s crude calculation.
The ratio is best used when screening through several companies, looking for specific characteristics. Momentum traders looking to make a watchlist of companies that might have to raise capital soon can use it to quickly narrow down their search to a few companies.
Value investors looking for stable, financially healthy businesses, can screen for high current ratio to narrow down the amount of companies they have to individually analyze.