What is the Current Ratio?
The Current Ratio is a way to evaluate a company financial health by determining if it has enough cash or other current assets to cover its current liabilities. Effectively the Current Ratio determines if a company can afford to pay its bills that are due within the next year.
The Current Ratio is a less conservative evaluation metric than the quick ratio, because it takes into account all current assets including inventory. The quick ratio does not factor in inventories, or other assets which could not potentially be converted into cash quickly.
The numbers needed to determine a company’s Current Ratio are found on the company’s most recent balance sheet statement, located within a 10-q or 10-k report, which can be found on the SEC’s website found here.
Example below from Intel’s (INTC) 2012 2nd quarter earnings found here.
(Click to enlarge)
The formula for the Current Ratio is:
Using Intel’s balance sheet above, we can determine Intel’s Current Ratio at the time:
Or, a Current Ratio of about 6.8.
This tells investors that Intel has more than enough money to cover its current liabilities.
A value of 1.0 would indicate that a company could just barely pay current liabilities with its current assets. A 1.0 value means current assets equal current liabilities.
The higher the value, the healthier the company’s short term finances are.
To compare the Current Ratio to the quick ratio, notice Intel’s quick ratio for the same quarter is 1.83 (see the quick ratio page here to see how that is calculated). This shows how excluding inventories and other more restricted current assets can change the appearance of a company’s short term finances. Before weighing the results from one ratio over another, be sure to consider what assets are included or excluded in each ratio. The quick ratio assumes no inventories will be sold, an unlikely scenario under any economy. However the current ratio is too inclusive, factoring in assets which may not be able to be quickly converted into assets.
Personally, I consider the quick ratio a “safer” evaluation metric due to its more conservative nature.
Interpretation of Financial Statements, Defines this as:
“One of the most frequently used figures and analyzing balance sheets is the ratio between current assets and current liabilities. When a company is in sound position, the current assets will exceed the current liabilities by a good margin, indicating that the company should have no difficulty in taking care of its current debts as they mature.
What constitutes a satisfactory current ratio varies to some extent with the line of business. In general, the more liquid the current assets the less the margin needed above current liabilities.”
Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports, Defines this as:
“The current ratio is one of the oldest and best-known measures of short-term financial strength. The ratio determines whether current assets are sufficient to pay current liabilities a current ratio for a general manufacturing company above 2.0 is considered good. It means that the company has twice the amount of current assets as it has current liabilities.”
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