Learn how to gauge a company’s short-term health using the current ratio.
When investors want to put money into a company, they often consider its long-term prospective future. They check the PE ratio to see if the stock is expensive compared to its earnings, or they look at the ROE to see how much profit the company makes on equity capital. Also, since debt can make or break a company, it is important to consider the debt-to-equity ratio.
Now, checking these ratios is not a bad idea. It is important because they give you a lot of information about the company.
But let us set all that aside and think about this: Can a company do well in the long term if it can’t pay its short-term bills.
The clear answer is no. But how can you, as an investor, know if a company can pay its bills on time? Or if it is facing some troubles?
That’s exactly what we are going to discuss today. We will see how you can determine a company’s short-term situation using the current ratio. We will also find out what is considered an ideal current ratio and how this ideal ratio can be different for different sectors.
What is Current Ratio?
The current ratio helps us understand the short-term financial health of companies. It helps us understand if a company can quickly pay off its short-term debts, which are the debts that need to be settled within a year.
Here, the company must have enough liquid or current assets to settle its short-term liabilities, and it must not rely on taking more debt or raising more capital by diluting its shareholding.
To determine the current ratio, we look at the current assets that can be turned into cash within a year. This includes cash, short-term investments like mutual funds, finished goods that can be sold for quick cash, payments pending from vendors, etc. Then, we compare this to their current liabilities that need to be paid in a year, like salaries and wages, raw material costs, tax, etc.
If the company has more current assets, it can quickly turn into cash compared to current liabilities they owe in the short term, and hence, that is a good sign. It means the company is in a solid position to pay off its short-term debts without any issues.
How is the Current Ratio Calculated?
The formula to calculate the current ratio is fairly simple.
Current Ratio Formula = Current Assets / Current Liabilities
You can easily find the current assets and liabilities in the company’s balance sheet.
Current assets include inventory, investments, trade receivable, cash and cash equivalents, bank balance, etc. Similarly, current liabilities include trade payables, salaries and wages, income tax, etc.
Now, you don’t have to hunt for the company’s balance sheet to calculate the current ratio; you can easily look for it on any stock screener.
Ideal Current Ratio
Let’s take an example. The current ratio of Avenue Supermarts is 3.58 as of 14th August 2023.
This number tells us that Avenue Supermarts has 3.58 times more current assets than its current liabilities. When the current ratio is higher, the company can handle its short-term liabilities better.
- The Current Ratio, which is greater than one, signals good news. It indicates that a company’s current assets are larger than its current liabilities or debts that need to be paid off in the short term. Companies with such a ratio tend to have strong cash flows and pose minimal credit risks.
- If the Current Ratio is less than one, this could raise concerns for investors. This occurs when a company’s current assets fall short of its current liabilities. In this case, the company might need to borrow extra money or sell some of its long-term assets to manage its debts. This situation carries a higher risk of cash crunch and other situations.
- When the Current Ratio is exactly 1, it suggests a balance between a company’s assets and liabilities. It means the company has just enough assets to cover its debts. However, even a slight cash flow dip could lead to problems in repaying debts.
- Lastly, an exceptionally elevated Current Ratio can indicate that the company is holding onto excessive cash. This might not be the best way to utilise investors’ funds effectively.
Investing in companies with a Current Ratio higher than one is a wise move. Generally, a higher Current Ratio is favourable.
There is no answer to the question ‘What is the ideal current ratio?’. It varies depending on the industry a company is in. For example, FMCG (Fast Moving Consumer Goods) giants usually keep their current ratio around one. This is because their business needs are met by building good relationships with suppliers. They can quickly turn their inventory into cash and manage their obligations well.
On the other hand, IT giants have current ratios that typically fall between 1.7 and 3. This is because their way of doing business relies heavily on getting orders, which can be cyclical.
Hence, while analysing ratios, you must keep in mind that you check the trend of the historical current ratio of the company.
Why do we say this?
Let’s say you are examining a company in an industry that goes through cycles, like a business that produces air coolers; the sales would naturally be at their peak during the summer and lower during the winter. These fluctuations directly affect the cash flows, influencing its current ratio. This is why it is essential to study the trends over a year to understand the company’s financial health truly.
With that, we come to the end of today’s discussion. As investors, knowing how the current ratio works gives us the power to make smart choices. But, apart from current ratios, there are many other liquidity ratios that you must look at, too, like quick ratio and acid test ratio, to understand the company’s situation in the short term.
*The article is for information purposes only. This is not an investment advice.