Current Ratio Meaning
Current ratio is the ratio which measures the ability of the company to repay the short term debts which are due within the period of the next one year and it is calculated by dividing the total current assets of the company with its total current liabilities.
It answers the question: “How many dollars in current assets are there to cover each dollar in current liabilities?” Does the company have sufficient resources to pay off its short-term obligations and stay afloat for at least one year?
Sears Holding stock fell by 9.8% on the back of continuing losses and poor quarterly results. Sears’s 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. One such ratio is to check the liquidity situation of the company is the Current Ratio. As you can see from above, this 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.
The current Ratio formula is nothing but Current Assets divided by Current Liability. If for a company, current assets are $200 million and current liability is $100 million, then the ratio will be = $200/$100 = 2.0.
|Current Assets||Current Liabilities|
|Cash & cash equivalents||Accounts Payable|
|Accounts Receivable and Accounts Payable||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 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 pay down the short term obligations.
- If Current Assets < Current Liabilities, then Ratio is less than 1.0 -> a problem situation at hand as the company does not have enough to pay for its short term obligations.
Which of the following companies is in 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 pay off 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.
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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 pay off their short term debt.
The Current Ratio is calculated as Current Assets of Colgate divided by the Current Liability of Colgate. For example, in 2011, Current Assets was $4,402 million, and Current Liability was $3,716 million.
= 4,402/3,716 = 1.18x
Likewise, we calculate the Current Ratio for all other years.
The following observations can be made with regards to Colgate Ratios –
This ratio increased from 1.00x in 2010 to 1.22x in the year 2012.
- The primary reason for this increase is 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 the current portion of long term debt to $895 million, thereby increasing the current liabilities.
Seasonality & Current Ratio
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 a clear pattern of seasonality in Current Ratios. Take, for example, Thomas Cook.
I have compiled below the total current assets and total current liabilities of Thomas Cook. You may note that this ratio of Thomas Cook tends to move up in the month of September Quarter.
Seasonality in the current ratio is normally seen in seasonal commodity-related businesses where raw materials like sugar, wheat, etc. are required. Such purchases are done annually, depending on 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 the US automobile sector.
Below is the list of US-listed automobile companies with high ratios.
|S. No||Company Name||Ratio|
|4||SORL Auto Parts||3.006|
|5||Fuji Heavy Industries||1.802|
Please note that a 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|
If the ratio is low due to the following reasons, it is again undesirable:
- Lack of sufficient funds to meet current obligations and
- A trading level beyond the capacity of the business.
- It 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 does not mean anything. It does not provide an insight on product profitability etc.
- This ratio can be manipulated by 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
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This has been a guide to what is the current ratio and its meaning. Here we discuss how to analyze the current ratio and its interpretation in accounting. If you gained something from the article or you have any further questions/suggestions, please do let me know from the comment box below.