What is current ratio in trading?
Investors and analysts would like to know how likely a company is to pay off any outstanding dues and short-term financial obligations to their clients or lenders. The better a company is at paying off their dues in a timely way, the safer it is for making an investment in. The current ratio tells investors just that. It acts as a liquidity ratio that measures the company’s ability to pay off its financial obligations within a year.
Specifically, it lets investors know how a company maximizes the assets that are currently on its balance sheet such that its debt and any other payables are satisfied. To estimate the current ratio of a company, its current assets are compared to its ongoing liabilities. Liabilities are limited to those that are short term, or payable within a year or less than that. The cash inflow of the company or any such assets that will be soon turned into cash is defined as the current assets of the company.
It is called a ‘current’ ratio because, in contrast to other liquidity ratios that exist, this particular estimate looks only at a company’s present assets and liabilities. Some refer to it as the company’s ‘working capital’ ratio. This is because this estimate helps investors get an idea of a company’s ability in covering its short term debts using its current holdings.
Currency Ratio Formula
The current ratio formula is pretty straightforward. One simply has to take the ratio of a company’s current assets and divide it by its current liabilities in the same duration, which is normally taken as one year. The formula is as follows:
Current Ratio = Current assets / Current liabilities
As per the current ratio formula, it is necessary to know the current assets and liabilities of a company. One can find the current assets of a company listed on its balance sheet. These include inventory, accounts receivable, cash, and other assets. As mentioned earlier, current assets also include those that can be converted to cash at some point in the next year. On the other hand, a company’s current liabilities can be found in the form of taxes, wages, accounts payable, and the current portion of long term debt.
The ideal current ratio falls in line with the industry average or slightly higher. If this ratio falls below the industry average, there is an indication of a greater risk of default or distress. Alternatively, suppose a company has a really high current ratio when contrasted with its competitors. This higher ratio can also be a sign that the management of the company is not using its assets as efficiently as possible.
Current Ratio Interpretation
When it comes to current ratio interpretation, investors use the following rule of thumb. Very simply, the higher the current ratio, the more capable a company appears when it comes to paying its dues is a year. This is because if the ratio is high, a company appears to have a greater proportion of short term assets relative to its short term liabilities in the same time frame. If the current ratio is under 1, the company’s outstanding debts due within a year or less are higher than its current assets.
These assets are its cash or any short-term assets which can easily be converted to cash and are expected to within the same timeframe measured. However, current ratio interpretation is not as simplistic as ‘higher is better.’ If a company’s ratio is over 3, for instance, this means it has the finances to cover its liabilities three times over but that is a more grave sign that the company is not managing its assets as efficiently as possible. It is not securing its financing well enough by using its working capital to its maximum profitability.
Ultimately, whether or not a current ratio can be pegged as ‘good’ or ‘bad’ will depend on how often the ratio changes. A company may currently boast an ideal current ratio which is gradually heading towards inefficiency in working capital. Alternatively, a company may have a current ratio under 1 but slowly build up over the years to reach acceptable levels. Ideally, one should seek out companies that boast of a good current ratio and, more importantly, maintain it.