How can the current ratio be misinterpreted by investors?

By Jean Folger AAA
A:

The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability to pay short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The current ratio is calculated by dividing current assets by current liabilities.

While current ratio can be used to evaluate a company’s financial health, the results can be misleading. One reason for this is that a high current ratio is not necessarily a good thing, and, similarly, a low current ratio is not automatically a bad thing. For example, assume company ABC has current assets of $1,000, current liabilities of $400 and a resulting current ratio of 2.5. Company XYZ, on the other hand, has current assets of $400, current liabilities of $400, and a resulting current ratio of 1.0. At first glance it may seem that company ABC is a better financial position to meets its obligations.

Let’s dig a little deeper. Assume both companies’ current liabilities have a payment period average of 30 days. Company ABC – with the higher current ratio – needs 180 days to collect its account receivables, and turns its inventory only twice per year. Company XYZ – with the lower current ratio – collects cash from its customers and turns its inventory 26 times per year. Despite the fact that XYZ has a lower ratio, it is in a better position and more liquid because of its faster cash conversion. Company ABC, though it has a higher current ratio, would have trouble operating because bills are coming in faster than cash.

The inventory component in the current ratio can also produce misleading results. For example, if a company’s current assets include a high percentage of inventory assets, the assets may be difficult to liquidate, and therefore, the company may not be as liquid as it appears in its current ratio.

As with other financial ratios, it is more useful to compare various companies within the same industry than to look at only one company, or to attempt to compare companies from different industries. In addition, investors should consider more than one ratio (or number) when making investment decisions since one figure cannot provide a comprehensive view of the company.

RELATED FAQS

  1. What is the On-Balance Volume (OBV) formula and how is it calculated?

    Read about the formula and calculation for On Balance Volume, or OBV, which is a technical indicator that shows movements ...
  2. What is the difference between the gearing ratio and the debt-to-equity ratio?

    Dive deeper into gearing ratios: what are they, how are they used and why the debt to equity ratio is one of the most popular ...
  3. What is the McGinley Dynamic Indicator formula and how is it calculated?

    Discover the McGinley dynamic indicator, which is designed to resolve issues based on the subjective placement and static ...
  4. What is the difference between interest coverage ratio and DSCR?

    Understand the basics of the interest coverage ratio and the debt-service coverage ratio, including calculations and how ...
RELATED TERMS
  1. Current Ratio

    A liquidity ratio that measures a company's ability to pay short-term ...
  2. Best's Capital Adequacy Relativity (BCAR)

    A rating of an insurance company’s balance sheet strength. Best’s ...
  3. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  4. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  5. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  6. Working Capital

    This ratio indicates whether a company has enough short term ...

You May Also Like

Related Articles
  1. A company's liabilities reveal how a company finances, plans and accounts for money it will need to pay at a future date.
    Fundamental Analysis

    Reviewing Liabilities On The Balance ...

  2. Fundamental Analysis

    Dynamic Current Ratio: What It Is And ...

  3. Trading Strategies

    Not All Online Trading Brokers Are Created ...

  4. Trading Strategies

    Novice Trading Strategies

  5. Fundamental Analysis

    Earnings Quality, the Facebook Example

Trading Center