Lesson 5: Liquidity Ratios, Current Ratio
We have seen that a ratio is a mathematical expression relating one number to another, often providing a relative comparison. Financial Ratios are no different; they form a basis of comparison between figures found on financial statements. As with all types of fundamental analysis, it is often most useful to compare the ratios of a firm to those of other companies.
We have seen that the Financial Ratio Analysis is a tool that was developed to perform quantitative analysis on numbers found on financial statements. Ratios help link the three financial statements together and offer figures that are comparable between companies and across industries and sectors. Ratio analysis is one of the most widely used fundamental analysis techniques.
And we have seen that the Financial Ratios fall into several categories. For this analysis, the commonly used ratios are grouped into five categories: Liquidity, Solvency, Profitability, Efficiency and Valuation.
We start now to see the first category, the Liquidity Ratios, and more in details the follow Financial Ratios:
- Current Ratio
- Quick Ratio
- Cash Ratio.
Current Ratio
The Current Ratio measures a company’s ability to repay short-term liabilities such as accounts payable and current debt using short-term assets such as cash, inventory and receivables. This ratio provides a good measure of solvency if accounts receivable and inventories are liquid.
The Current ratio is useful as it shows whether a company has adequate resources to repay short-term debt or if it will experience cash flow problems in the near term. A ratio of 2:1 is usually considered the benchmark. However, this may vary across industries.
A Higher value of Current Ratio indicates more liquid of the company's ability to pay its current obligation in time. On the other hand, a ratio of less than one suggests that the company may not have sufficient resources to settle its short-term debt obligations if they fell due today.
The Current Ratio formula is the following:
The two essential components of this ratio are current assets and current liabilities. Current asset means typically assets which can be easily converted into cash within a year's time. On the other hand, current liabilities represent those liabilities which are payable within a year.
Below, in details, the components of current assets and current liabilities for measuring the Current Ratio:
- Current Assets = Cash & Bank Balance + Inventories + Debtors + Bills Receivable + Prepaid Expenses + Investments readily convertible into cash + Loans and Advances.
- Current Liabilities = Creditors + Bills Payable + Bank Overdraft + Unclaimed dividend + Provision for Taxation + Proposed Dividend.
Example
A Company has currents assets for $ 80,000 and current liabilities in the amount of $ 30,000. All of this gives a gives a current ratio of 2.67.
Thus, the company has about two and a half times more current assets than current liabilities. This number is useful for the comparison with industry trends but includes so many items from the financial statements that a deeper dive is often required to determine if a ratio is “good.”
For example, a company using a just-in-time inventory system may have low inventory, making their current ratio lower but not necessarily indicating that there is a problem with meeting short-term obligations. Likewise, a company with bloated inventory may have a high current ratio and still have problems meeting short-term obligations.
For this reason, for a more conservative alternative, the numerator (Current Assets) may be adjusted removing the inventories, as they can be viewed as not very readily convertible to cash. This ratio is known as the Quick Ratio. Quick Ratio that we will see in the next article.
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