Financial Statement Analysis

- Liquidity Ratios
- Cash Ratio
- Cash Ratio Formula
- Quick Ratio
- Quick Ratio Formula
- Current Ratio
- Current Ratio Formula
- Acid Test Ratio Formula
- Defensive Interval Ratio
- Working Capital Ratio
- Working Capital Formula
- Net Working Capital Formula
- Changes in Net Working Capital
- Change in Net Working Capital (NWC) Formula
- Cash Flow from Operations Ratio
- Cash Flow Per Share
- Cash Reserve Ratio
- Operating Cycle Formula
- Current Ratio vs Quick Ratio
- Bid Ask Spread
- Liquidity vs Solvency
- Liquidity
- Accounting Liquidity
- Solvency
- Solvency Ratios
- Equity Ratio
- Capital Adequacy Ratio
- Cash Reserve Ratio Formula
- Liquidity Risk
- Altman Z Score

- Ratio Analysis (17+)
- Turnover Ratios (17+)
- Profitability Ratios (66+)
- Efficiency Ratios (7+)
- Dividend Ratios (9+)
- Debt Ratios (26+)

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**Current Ratio – **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, the 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, we will discuss the following –

- What is Current Ratio?
- Current Ratio Formula
- Meaning
- Example
- Colgate – in-depth calculation
- Seasonality in – Thomas Cook Example
- examples in Automobile Sector (highs and lows)
- Limitations

## What is Current Ratio?

The current ratio is used to measure a 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 **at least one year. **

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### Current Ratio Formula

Current Ratio formula 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 Formula = $200/$100 = 2.0.

Current Assets |
Current Liabilities |

Cash & cash equivalents | Accounts Payable |

Investments | Deferred Revenues |

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 |

Prepaid expenses | |

Advance payments |

### Interpretation of Current Ratios

- If
**Current Assets > Current Liabilities,**then Ratio is greater than 1.0 -> a desirable situation to be in. - If
**Current Assets = Current Liabilities,**then Ratio is equal to 1.0 -> Current Assets are just enough to paydown the short term obligations. - If
**Current Assets < Current Liabilities**, then 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 a current ratio 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.

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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 nonpayments of receivables.

However, if you look at Company B now, it has all cash in its current assets. Even though it’s 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 Example

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.

Current Ratio Formula = 4,402/3,716 = 1.18x

Likewise, we calculate Current Ratio for all other years.

Following observations can be made with regards to Colgate Ratios –

This 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 its 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.

### Current Ratio Example of Seasonality

It should not be analyzed in isolation for a specific period. We should closely observe this ratio over a period of time – whether the 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 this ratio 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 ratios, i have picked up US automobile sector.

Below is the list of US listed automobile companies with high ratios.

S. No |
Company Name |
Ratio |

1 | Ferrari | 4.659 |

2 | Supreme Industries | 3.587 |

3 | Ford Motor | 3.149 |

4 | SORL Auto Parts | 3.006 |

5 | Fuji Heavy Industries | 1.802 |

6 | Sime Darby | 1.71 |

7 | Isuzu Motors | 1.603 |

8 | Nissan Motor | 1.588 |

9 | Mitsubishi Motors | 1.569 |

10 | Toyota Industries | 1.548 |

Please note that Higher 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 ratios.

S. No | Company Name | Ratio |

1 | Saleen Automotive | 0.0377 |

2 | BYD Co | 0.763 |

3 | Greenkraft | 0.7684 |

4 | BMW | 0.935 |

If the 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.
- This ratio in isolation do not mean anything. It does not provide an insight on product profitability etc.
- This ratio 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 the ratio.

### Current Ratio Video

#### Recommended Articles –

- What are the Medium-Term Notes (MTN)?
- Features of Deferred Revenue Expenditure
- Accrued Income Journal Entry Examples
- Acid Test Ratio Calculator
- Trade Receivables
- Accounts Receivable vs Accounts Payable | Top 7 Differences
- Current Ratio vs Quick Ratio | Top Differences
- Cash Ratio
- Acid Test Ratio

### What next?

If you gained something from the article or you have any further questions/suggestions, please do let me know from the comment box below.

Happy Learning!

Polina says

Very clear and helpfull! Thank you very much 🙂

Dheeraj Vaidya says

Thanks Polina!

Prasanth Kumar says

Thank you very much. Highly Helpful

Dheeraj says

Thanks Prasanth!

Hiral says

Hi Dheeraj thanks for interpertation for Current Ratio

Dheeraj says

thanks Hiral!

Suman says

Hi Dheeraj,

Very Nicely explanined.

Suman

Dheeraj says

Thanks Suman!

Hitesh Sachdev says

TY this was really helpfull.

Dheeraj says

Thanks Hitesh!

Kaustubh says

Hi Dheeraj, Thanks for bringing out Devils in Current Ratio with such Detailed explanation.I have a question.As per the article, Current ratio can be misleading in evaluating liquidity of firm depending upon kind of current asset that goes in the numerator(Current Assets).Clearly, Cash and Cash Equivalents seem to be the most reliable current asset for short term solvency of a firm.So my question is; if the purpose of this analysis is to determine short term liquidity, why to check Current Ratios instead of directly checking Cash Ratio or Quick Ratio? Thanks!!

Jason says

Thank you for the post. A good material for review.

Dheeraj says

Thank you Jason!

Devansh Lakhani says

Insightful article.

Dheeraj says

Thanks Devansh!