If you are an investor, the current ratio is a measure you’ll likely want to use to analyze the companies in which you are considering investing. The current ratio is a liquidity measure. It determines whether a company is likely to be able to pay its short-term obligations. There is a relatively simple formula you can use to find the current ratio. From there, you can use it to decide whether or not a company is a good investment. If all of this sounds overwhelming, consider finding a financial advisor to help you with SmartAsset’s free financial advisor matching service.
What Is the Current Ratio?
The current ratio is a measure of how likely a company is to be able to pay its debts in the short term. Short-term debts are generally money owed within a year. It is essentially a liquidity ratio, measuring a firm’s assets versus how much it owes.
There is a simple formula for finding the current ratio:
Current Ratio = Current Assets/Current Liabilities
As an example, let’s say The Widget Firm currently has $1 million in cash and easily convertible assets and debts of $800,000 due in the following year. We can plug this information into the formula to find the current ratio.
Current Ratio = $1,000,000/$800,000
Current Ratio = 1.25
Now that you know the current ratio, you can use it as part of your analysis of the company. The following section explains exactly how to use the current ratio in your analysis.
How to Use the Current Ratio
It is easy to calculate the current ratio, but it takes a bit more nuance to actually employ it as a method of stock analysis. There isn’t a specific number you are looking for when calculating the current ratio. However, there are some basic inferences you can take from the current ratio once you’ve calculated it.
For instance, if the current ratio is less than one, this means that the company’s outstanding debts owed within a year are higher than the current assets the company holds. This is generally not a good sign, as it could mean the company is in danger of becoming delinquent on its payments, which is never good. Keep in mind, though, that the company may simply be awaiting a big influx of cash, whether in the form of a new investment or payment for a big sale of the product it manufactures.
A particularly high current ratio also may not be a good sign. If the current ratio is close to five, for instance, that means the company has five times as much cash on hand as its current debts. While the company is obviously not in danger of going bankrupt, it has a huge amount of cash or easily convertible assets simply sitting in its coffers. A company could reinvest that money. It could hire more employees, build a new facility or expand its product line. The fact that it is not doing so could be signs of mismanagement or inefficiency.
Interpreting Changes to the Current Ratio
While the current ratio at any given time is important, analysts and investors should also consider how the number has changed over time. That could show how the company is changing and what trajectory it is on.
If a company’s current ratio goes up over time, this could mean that it is paying off its debts or bringing in new revenue streams. Investors and analysts should investigate to see what caused the change. It’s possible a new management team has come in and righted the ship of a company that was in trouble, which could make it a good investment target.
A current ratio going down could mean that the company is picking up new or bigger debts. It could mean their revenue has gone down. Again, analysts and investors should investigate the cause to determine whether the company is a good investment.
The Bottom Line
The current ratio measures a company’s current assets compared to its debts. It is calculated through a simple formula of dividing a company’s total assets (cash and easily convertible assets) by its short-term debts, generally those due within a year. Once you’ve calculated the current ratio, you can draw inferences about the company. These may help you decide whether or not it is a good target for investment. Don’t just look at the current ratio at any given time though. Also consider how the current ratio has changed over time and what that might mean for a company’s trajectory.
- Is calculating the current ratio too much for you? Consider finding a financial advisor who can help you make investment decisions. Find one with SmartAsset’s free financial advisor matching service. You answer a few questions. We match you with up to three advisors in your area, all fully vetted and free of disclosures. You then talk to each advisor and decide how to move forward.
- Capital gains taxes are a part of investing. If you want to see how much you may owe when you sell, use SmartAsset’s free capital gains tax calculator.
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