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 formula for calculating the current ratio?

    Find out how to calculate the current ratio and what that result can tell you about a potential investment. Read Answer >>
  2. What are some alternative liquidity ratios to the cash ratio?

    Learn what the cash ratio measures, and understand what two other liquidity ratios can be used by a company to replace the ... Read Answer >>
  3. What are the main differences between the current ratio and the quick ratio?

    Find out how the quick ratio and the current ratio can offer different views on a company's ability to pay off liabilities. Read Answer >>
  4. How can a company quickly increase its liquidity ratio?

    Discover what high and low values in the liquidity ratio mean and what steps companies can take to improve liquidity ratios ... Read Answer >>
  5. What is the relationship between the cash ratio and liquidity?

    Understand the relationship between a company's cash ratio and its liquidity. Learn what the cash ratio measures and what ... Read Answer >>
  6. To what extent should you take a company's liquidity ratio into account before investing ...

    Find out how important it is for an investor to know a company's liquidity ratio before deciding to invest, and why relying ... Read Answer >>
Related Articles
  1. Investing Basics

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
  2. Fundamental Analysis

    Dynamic Current Ratio: What It Is And How To Use It

    Learn why this ratio may be a good alternative to the current, cash and quick ratios.
  3. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  4. Investing Basics

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  5. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  6. Trading Strategies

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  7. Fundamental Analysis

    Financial Analysis: Solvency Vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health. A number of financial ratios are used to measure a company’s liquidity and solvency, and an investor should use ...
  8. Investing Basics

    The Working Capital Position

    Learn how to correctly analyze a company's liquidity and beat the average investor.
  9. Term

    What Are Quick Assets?

    A company’s quick assets can be easily converted into cash.
  10. Economics

    What is the Cash Ratio?

    The cash ratio is the ratio of a company's total cash and cash equivalents to its current liabilities.
RELATED TERMS
  1. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
  2. Cash Asset Ratio

    The current value of marketable securities and cash, divided ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. ...
  4. Cash Ratio

    The ratio of a company's total cash and cash equivalents to its ...
  5. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  6. Liquidity Ratios

    A class of financial metrics that is used to determine a company's ...
Hot Definitions
  1. Physical Capital

    Physical capital is one of the three main factors of production in economic theory. It consists of manmade goods that assist ...
  2. Reverse Mortgage

    A type of mortgage in which a homeowner can borrow money against the value of his or her home. No repayment of the mortgage ...
  3. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  4. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  5. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  6. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
Trading Center