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:

Current ratio = current assets / current liabilities

As of March 31, 2014, for example, Microsoft’s (MSFT) balance sheet listed the following:

Current Assets:

Cash and cash equivalents

$11,572,000

Short-term investments

$76,853,000

Net receivables

$14,921,000

Inventory

$1,920,000

Other current assets

$3,740,000

Total current assets

$109,006,000

Current Liabilities:

Accounts payable

$9,958,000

Short-term debt

$2,000,000

Other current liabilities

$21,945,000

Total current liabilities

$33,903,000

To determine MSFT’s current ratio, we divide current assets by current liabilities:

MSFT current ratio = $109,006,000 / $33,903,000 = 3.22

The current ratio can provide investors and analysts with clues about the efficiency of a company’s operating cycle or its ability to monetize its products. The higher the ratio, the more able a company is to pay off its obligations. While acceptable ratios vary depending on the specific industry, a ratio between 1.5 and 3 is generally considered healthy. Investors and analysts would consider MSFT, with a current ratio of 3.22, financially healthy and capable of paying off its obligations.

Liquidity problems can arise for companies that have difficulty getting paid on their receivables or that have slow inventory turnover because they can’t satisfy their obligations. A ratio under 1 implies that a company would be unable to pay off its obligations if they become due at that point in time. A ratio under 1 does not necessarily mean that a company will go bankrupt since it may be able to secure other forms of financing; however, it does indicate the company is not in good financial health. A ratio that is too high may indicate that the company is not efficiently using its current assets or short-term financing.

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 cannot provide a comprehensive view of the company.

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