How to Analyze a Company’s Current Ratio

Introduction

A company's current ratio, also known as its liquidity ratio, is an important measure of financial health. It is a comparison of a company's current assets to its current liabilities and is an indication of whether a business has sufficient short-term assets to cover its short-term liabilities. If a company has a higher than average current ratio, this could be a sign that the company is doing well financially. Analyzing a company's current ratio is a key step in determining the company's current financial health.

A company's current ratio is calculated by dividing its current assets by its current liabilities. This ratio provides an indication of the company's liquidity and ability to cover its short-term liabilities with its available assets. Generally, a current ratio of 1.0 or higher is considered to be healthy. A number lower than 1.0 might indicate that the company does not have sufficient short-term assets to cover its short-term liabilities. Companies that have a current ratio of less than 1.0 could be at risk of becoming insolvent or unable to meet its short-term obligations.

It's important for businesses to analyze their current ratio regularly to stay on top of their financial health. Below are some tips for how to analyze a company's current ratio.

Calculating a Company's Current Ratio

Calculating a company's current ratio is an important step in evaluating the financial health of the company. This ratio helps investors and managers determine whether a company has adequate short-term financial resources to pay off its current liabilities. The current ratio, also known as the working capital ratio, indicates the extent to which a company’s current assets cover its current liabilities. This ratio is a short-term financial indicator of a company’s ability to meet its obligations.

Breaking Down the Components of the Current Ratio

The current ratio equation is calculated by dividing a company’s total current assets by its total current liabilities. Current assets are defined as assets that can be converted into cash or used to pay off liabilities in the short-term. These assets can be liquidated to meet the company's current obligations. Common types of current assets include cash, accounts receivable, and inventory. Current liabilities, on the other hand, refer to liabilities that need to be paid within the current operating cycle. As a result, current liabilities are sometimes known as short-term liabilities. Examples of current liabilities include accounts payable, payroll liabilities, taxes payable, and short-term loans.

Step-by-Step Calculation

To calculate the current ratio of a particular company, investors must first gather the relevant financial information. This usually includes the latest balance sheet statement and income statement. Once the financial data has been collected, the following steps must be taken to perform a current ratio calculation:

• Step 1: Add up current assets, which include cash, accounts receivable (invoices), inventory, and any other assets that can be converted into cash or used to pay off current liabilities.
• Step 2: Add up current liabilities, which include accounts payable, payroll liabilities, taxes payable, and short-term debt.
• Step 3: Divide total current assets by total current liabilities. For example, if a company has total current assets of $125,000 and total current liabilities of $90,000, then its current ratio is 1.39 ($125,000/$90,000).

It should be noted that a company’s current ratio should ideally be between 1.2 to 2. If a company’s current ratio is below 1.2, it may be in danger of insolvency. Conversely, a current ratio of 3 or higher may indicate a poor use of capital. Investors should also consider industry averages when evaluating a company’s current ratio.

How Financing Impacts the Current Ratio

Financing through loans or bonds can play a significant role in impacting a company’s current ratio. When a company takes out a loan or issues bonds, it raises cash, either to purchase additional inventory or to expand operations. This additional cash can cause the current ratio to rise, providing a strong source of liquidity to the company.

Implications of Taking out Loans or Issuing Bonds

Taking out a loan or issuing bonds often requires the company to take on more debt. This can be viewed as increasing the company’s liabilities, which can result in a decrease in the current ratio. Not only that, but the additional debt service payments can reduce the amount of money that is available for the purchase of additional inventory or other operational expenses, which can further reduce the liquidity of the company.

Impact on Debt Repayment Ability

Higher amounts of debt can also impact the company’s ability to repay its creditors. By increasing the debt load of the company, it can limit the cash flows available for repayment of existing debt. This can cause the current ratio to decline, which can result in higher borrowing costs and lower liquidity for the company.

In addition to the impact on the current ratio, the financing can also impact the creditworthiness of the company. If the additional debt taken on is high enough, it can cause the company to be seen as less creditworthy, which can result in higher borrowing costs.

4. Monitoring the Ratio Over Time

Analyzing a company’s current ratio over time is an important part of deciding if it is a potential investment. Monitoring the current ratio helps to assess the company’s liquidity at different points in time. This can be useful for investors to ensure the company has adequate cushion in order to cover any unexpected expenses that may arise.

a. Analyzing if the Company has Healthy Liquidity

The current ratio shows the capabilities of a company to pay its short-term debts. A current ratio of around 1.5 is usually considered to be healthy in indicating that the company has sufficient liquidity available to cover its current liabilities. A ratio under 1 may indicate that the company is unable to cover its current debts. However, it is important to consider the industry when looking at the current ratio as some industries may have a higher ratio that is still considered normal.

b. How Increases or Decreases in Current Ratio May Impact Investment Decisions

When looking at the current ratio of a company, investors should look for any upward or downward trends in the company’s ratio over time. If the company has a consistent increase in its current ratio over time, this may indicate that the company has improved its short-term liquidity and is becoming a stronger investment. If the ratio is decreasing or stagnant, it may be an indication that the company is struggling to keep up with its short-term debts.

Investors should also look at the comparison of the current ratio against similar companies in the same industry. This helps to gain a better understanding of the health of the company’s liquidity in comparison to its competitors.

Analyzing a Company's Industry Current Ratios

When assessing a company’s financial health, its current ratio is one of the most important metrics to consider. A company’s current ratio drives how well it can handle short-term obligations and how quickly it can pay off its short-term liabilities. Analyzing a company’s current ratio in the broader context of its industry can help lenders, investors, and stakeholders get a better picture of the company’s financial picture.

Analyzing Competitors' Current Ratios to Develop Benchmark

A company’s current ratio can be evaluated more meaningfully when compared to its competitors in the industry. Conducting a competition analysis should involve considering competitors’ last five years’ current ratios and weighting them against each other to develop a benchmark. For example, if a company has averaged a current ratio of 1.2 while its competitors have averaged 1.8 over the past five years, then the company’s current ratio should be considered low.

How Novel Products Could Change Industry Current Ratio Trend

Changes in industry forces can also affect a company’s current ratio. For example, introducing a novel product to the market can cause short-term liabilities (e.g. inventory) to spike relative to current assets, thus lowering the current ratio. This could be a sign of growth as long as the company is well-equipped to handle the added cost of production. It is important for investors and lenders to analyze the company’s current ratio trend over the past five years to look for abnormal changes driven by industry dynamics.

Evaluating a company’s current ratio alongside its industry counterparts is an effective way of gauging its liquidity and financial health. A strong current ratio can show lenders and investors that the company has a healthy financial position and can meet its short-term liabilities. While high current ratios may indicate strong financial performance, investors must also be mindful of unique industry dynamics that could significantly change the current ratio trend.

Interpreting the Results

Once the current ratio of a company has been determined, there are a few things to consider in terms of how that result should be interpreted. First, the current ratio can be used as an indicator of risk. Companies with current ratios below 1.0 are said to be in a 'distressed financial state' and are at an increased risk for default. While companies with a current ratio above 1.0 are not necessarily in a great financial position, the higher ratio can be a sign that the company is less likely to default on their debts.

It is also important to understand the components of the balance sheet when interpreting the results of the current ratio. The higher value of current assets versus current liabilities can be degraded if a significant portion of the current assets is made up of inventory that is quickly perishable. This is because this inventory cannot be used to pay off short-term debt as it will be used or expire before it can be sold to create cash.

Conclusion

The current ratio is a key financial ratio that can give investors insight into a company’s ability to pay its current liabilities. By analyzing a company’s current ratio, investors can gain insight into the company’s overall financial health, as a higher current ratio indicates that the company is able to generate enough revenues to meet its current liabilities. Furthermore, investors can use this ratio to compare the performance of their company to similar businesses in their industry.

Just as with any financial ratio, the current ratio is not a perfect indicator of a company’s financial health. It is important to consider other indicators, like debt levels and operating expenses to get a full understanding of the company’s financial performance.

In conclusion, analyzing a company’s current ratio is an important part of understanding the company’s overall financial health and ability to pay back its liabilities. By considering the current ratio as well as other financial indicators, investors can gain better insight into the financial performance of their portfolio companies.