Current Ratio is a liquidity ratio that measures company's ability to pay its debt over the
next 12 months or its business cycle. Current Ratio formula is:
Current Ratio = Current Assets/Current Liabilities
Current ratio is a financial ratio that measures whether or not a company has enough resources to pay its debt over the next business cycle (usually 12 months) by comparing firm's current assets to its current liabilities.
Acceptable current ratio values vary from industry to industry. Generally, a current ratio of 2:1 is considered to be acceptable. The higher the current ratio is, the more capable the company is to pay its obligations. Current ratio is also affected by seasonality.
If current ratio is bellow 1 (current liabilities exceed current assets), then the company may have problems paying its bills on time. However, low values do not indicate a critical problem but should concern the management. One exception to the rule is considered fastfood industry because the inventory turns over much more rapidly than the accounts payable becoming due.
Current ratio gives an idea of company's operating efficiency. A high ratio indicates "safe" liquidity, but also it can be a signal that the company has problems getting paid on its receivable or have long inventory turnover, both symptoms that the company may not be efficiently using its current assets.
Current Ratio is the liquidity ratio and shows company's ability to pay its debt over the accounting period. Current depicts whether or not a company has enough resources to pay its debt over the next accounting period by comparing firm's current assets to its current liabilities
Generally, a current ratio of 2:1 is considered to be acceptable. Generally, higher the
current ratio, more capability for paying obligations but it’s not always the case as here in
case of XYZ company.
So, it happens with the companies that with higher current ratio they are yet not able to pay
their obligations as due to poor operating efficiency.
As current ratio also shows the operating efficiency of the company’s assets, thus as XYZ
company is not able to pay liabilities even with its 4:1 CR, thus means their operating
efficiency is very low and problems getting paid on its receivable or have long inventory
turnover, both symptoms that the company may not be efficiently using its current assets.
The current ratio is another test of a company's financial strength. It calculates how many
dollars in assets are likely to be converted to cash within one year in order to pay debts that
come due during the same year. You can find the current ratio by dividing the total current
assets by the total current liabilities. For example, if a company has $10 million in current
assets and $5 million in current liabilities, the current ratio would be 2 (10/5 = 2).
An acceptable current ratio varies by industry. Generally speaking, the more liquid the
current assets, the smaller the current ratio can be without cause for concern. For most
industrial companies, 1.5 is an acceptable current ratio. As the number approaches or falls
below 1 (which means the company has a negative working capital), you will need to take
a close look at the business and make sure there are no liquidity issues. Companies that
have ratios around or below 1 should only be those which have inventories that can
immediately be converted into cash. If this is not the case and a company's number is low,
you should be seriously concerned.
Inefficiency:
If you're analyzing a balance sheet and find a company has a current ratio of 3 or 4, you
may want to be concerned. A number this high means that management has so much cash
on hand, they may be doing a poor job of investing it. This is one of the reasons it is
important to read the annual report, 10K and 10Q of a company. Most of the time, the
executives will discuss their plans in these reports. If you notice a large pile of cash
building up and the debt has not increased at the same rate (meaning the money is not
borrowed), you may want to try to find out what is going on.
Microsoft has a current ratio in excess of 4, a massive number compared to what it
requires for its daily operations. The company has no long term debt on the balance sheet.
What are they planning on doing? No one knew until the company paid its first dividend in
history, bought back billions of dollars worth of shares, and made strategic acquisitions.
Although not ideal, too much cash on hand is the kind of problem a smart investor prays
for
Current Ratio is the liquidity ratio & depicts whether or not a company has enough
resources to pay its debt over the next accounting period.
Generally, a current ratio of 2:1 is considered to be acceptable & higher the current ratio,
more capability for paying obligations but it’s not always the case.
As XYZ has a higher Current ratio (4:1) but still unable to pay its obligations which is due
to poor operating efficiency of the current assets and possible symptoms are, problems
getting paid on its receivable or have long inventory turnover.
This indicates that the decreased inventory turnover and increased accounts receivable
turnover Which should be managed so that inventory turnover is increased and accounts
receivable turnover is decreased so that XYZ should be able to pay its obligations.
