Sears Holding stock fell by 9.8% on the back of continuing losses and poor quarterly results. Sears balance doesn’t look too good either. Moneymorning has named Sears Holding as one of the five companies that may go bankrupt soon. In this context, an analyst can quickly perform financial ratio analysis to check if this may be true. Once such ratio is to check the liquidity situation of the company is Current Ratio. As you can see from above, Current ratio of Sears has been dropping continuously for the past 10 years. It is now below 1.0x and does not portray the right picture.
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In this article on Current ratios, we will discuss the following –
- What is Current Ratio?
- Current Ratio Formula
- Interpretation of Current Ratio
- Current Ratio Example
- Current Ratio of Colgate – in-depth calculation
- Seasonality in Current Ratio – Thomas Cook Example
- Current Ratio examples in Automobile Sector (highs and lows)
- Limitations of Current Ratio
What is Current Ratio?
The current ratio is used to measure company’s short term liquidity position and provides a quantitative relationship between current assets (CA) and current liabilities (CL).
It answers the question: “How many dollars in current assets are there to cover each dollar in current liabilities?” Does the company has sufficient resources to pay off its short term obligations and stay afloat for atleast one year.
Current Ratio Formula
Current Ratio is nothing but Current Assets divided by Current Liability. If for a company, current assets is $200 million and current liability is $100 million, then the Current Ratio = $200/$100 = 2.0.
|Current Assets||Current Liabilities|
|Cash & cash equivalents||Accounts Payable|
|Accounts receivable, or trade receivables||Accrued Compensation|
|Notes receivable maturing within one year||Other accrued expenses|
|Other receivables||Accrued Income Taxes|
|Inventory of raw materials, WIP, finished goods||Short Term notes|
|Office supplies||Current Portion of Long term debt|
Interpretation of Current Ratios
- If Current Assets > Current Liabilities, then Current Ratio is greater than 1.0 -> a desirable situation to be in.
- If Current Assets = Current Liabilities, then Current Ratio is equal to 1.0 -> Current Assets are just enough to paydown the short term obligations.
- If Current Assets < Current Liabilities, then Current Ratio is less than 1.0 -> a problem situation at hands as the company does not have enough to pay for its short term obligations.
Current Ratio Example
Let us work through an example to understand this in detail.
Which of the following companies is in a a better position to pay its short term debt?
From the above table, it is pretty clear that company C has $2.22 of Current Assets for each $1.0 of its liabilities. Company C is more liquid and is apparently in a better position to payoff its liabilities.
However, please note that we must investigate further if our conclusion is actually true.
Let me now give you a further breakup of Current Assets and we will try and answer the same question again.
Please accept – The devil is in the details
Company C has all of its current assets as Inventory. For paying the short term debt, company C will have to move the inventory into sales and receive cash from customers. Inventory takes time to be converted to Cash. The typical flow will be Raw Material inventory -> WIP Inventory -> Finished goods Inventory -> Sales Process takes place -> Cash is received. This cycle may take a longer time. As Inventory is less than receivables or cash, the current ratio of 2.22x does not look too great this time.
Company A, however, has all of its current assets as Receivables. For paying off the short term debt, company A will have to recover this amount from its customers. There is a certain risk associated with non payments of receivables.
However, if you look at Company B now, it has all cash in its current assets. Even though its Current Ratio is 1.45x, strictly from the short term debt repayment perspective, it is best placed as they can immediately payoff their short term debt.
Colgate Current Ratios
Current Ratio is calculated as Current Assets of Colgate divided by Current Liability of Colgate. For example, in 2011, Current Assets was $4,402 million and Current Liability was $3,716 million.
Colgate Current Ratio (2011) = 4,402/3,716 = 1.18x
Likewise we calculate the current ratio for all other years.
Following observations can be made with regards to Colgate Current Ratios –
Current ratio increased from 1.00x in 2010 to 1.22x in year 2012.
- Primary reason for this increase is the built-up of cash and cash equivalents and other assets from 2010 to 2012. In addition, we saw that the current liabilities were more or less stagnant at around $3,700 million for these three years.
- We also note that current ratio dipped to 1.08x in 2013. The primary reason for this dip is the increase in current portion of long term debt to $895 million, thereby increasing the current liabilities.
Seasonality in Current Ratio
Current Ratios should not be analyzed in isolation for a specific period. We should closely observe this ratio over a period of time – whether current ratio is showing a steady increase or a decrease. In many cases, however, you will note that there is no such pattern. Instead, there is clear pattern of seasonality in Current Ratios. Take for example, Thomas Cook.
I have compiled below total current assets and total current liabilities of Thomas Cook. You may note that the current ratios of Thomas Cook tend to move up in the month of September Quarter.
Seasonality in current ratio is normally seen in seasonal commodity related business where raw materials like sugar, wheat etc are required. Such purchases are done annually depending on the availability and are consumed throughout the year. Such purchases require higher investments (generally financed by debt) thereby increasing the current asset side.
Current Ratio Examples in Automobile Sector
So as to give you an idea of sector current ratios, i have picked up US automobile sector.
Below is the list of US listed automobile companies with high current ratios.
|S. No||Company Name||Current Ratio|
|4||SORL Auto Parts||3.006|
|5||Fuji Heavy Industries||1.802|
Please note that Higher current ratio may not necessarily mean that they are in a better position. It could also be because of –
- slow moving stocks or
- lack of investment opportunities.
- Also, the receivables collection could also be slow.
Below is the list of US listed automobile companies with low current ratios.
|S. No||Company Name||Current Ratio|
If the current ratio is low due to following reasons it is again undesirable:
- Lack of sufficient funds to meet current obligations and
- Trading level beyond the capacity of the business.
Limitations of Current Ratio
- Does not focus on the breakup of Assets or Asset Quality. The example that we saw earlier Company A (all receivables), B (all cash) and C (all inventory) provide different interpretations of Current ratios.
- Current ratios in isolation do not mean anything. It does not provide an insight on product profitability etc.
- Current Ratios can be manipulated by the management. An equal increase in both current assets and current liabilities would decrease the ratio and likewise, an equal decrease in current assets and current liabilities would increase current ratio.
If you gained something from the article or you have any further questions/suggestions, please do let me know from the comment box below.