The current ratio is an accounting measure that tells you if a company can pay such short-term obligations as payroll and rent for the year. A good metric for investors to use when analyzing securities, the current ratio is a relatively simple calculation: current assets divided by current liabilities. What’s not so simple is how to use the ratio. If this sounds like more than you want to take on, a financial advisor can help you with your investments. To find the right one for you, use SmartAsset’s free financial advisor matching service.
What Is the Current Ratio?
The current ratio is a measure of how likely a company is to be able to pay its debts in the short term. Short-term debts are generally money owed within a year. The current ratio essentially indicates liquidity. Below 1 means the company will not be able to pay its debts within the year.
The formula for calculating the current ratio is:
Current Ratio = Current Assets/Current Liabilities
As an example, let’s say The Widget Firm currently has $1 million in cash and easily convertible assets (e.g., inventory) and $800,000 in debts due in the year (e.g., payroll and taxes). We can plug this information into the formula to find the current ratio.
Current Ratio = $1,000,000/$800,000
Current Ratio = 1.25
Now that you know the current ratio, you can use it as part of your analysis of the company. The following section explains exactly how to use the current ratio in your analysis.
How to Use the Current Ratio
It is easy to calculate the current ratio, but it takes a bit more nuance to employ it as a method of stock analysis. There isn’t a specific number you are looking for when calculating the current ratio. However, there are some basic inferences you can take from the current ratio once you’ve calculated it.
For instance, if the current ratio is less than 1, this means that the company’s outstanding debts owed within a year are higher than the current assets the company holds. This is generally not a good sign, as it could mean the company is in danger of becoming delinquent on its payments, which is never good. Keep in mind, though, that the company may simply be awaiting a big influx of cash, whether in the form of a new investment or payment for a big sale of the product it manufactures.
A particularly high current ratio also may not be a good sign. What makes for a high current ratio varies from industry to industry (restaurants tend to have lower current ratios than technology companies). If the current ratio is close to five, for instance, that means the company has five times as much cash on hand as its current debts. While the company is obviously not in danger of going bankrupt, it has a huge amount of cash or easily convertible assets simply sitting in its coffers. A company could reinvest that money. It could hire more employees, build a new facility or expand its product line. The fact that it is not doing so could be signs of mismanagement or inefficiency.
Interpreting Changes to the Current Ratio
While the current ratio at any given time is important, analysts and investors should also consider how the number has changed over time. That could show how the company is changing and what trajectory it is on.
If a company’s current ratio goes up over time, this could mean that it is paying off its debts or bringing in new revenue streams. Investors and analysts should investigate to see what caused the change. It’s possible a new management team has come in and righted the ship of a company that was in trouble, which could make it a good investment target.
A current ratio going down could mean that the company is picking up new or bigger debts. It could mean their revenue has gone down. Again, analysts and investors should investigate the cause to determine whether the company is a good investment.
The Bottom Line
The current ratio compares a company’s current assets to the debts that it will have to pay within the year. It is simply calculated by dividing a company’s total assets (cash and easily convertible assets) by its short-term debts (accounts payable for the year). Once you’ve calculated the current ratio, you can draw inferences about the company. These may help you decide whether or not it is a good investment. Don’t just look at the current ratio at any given time though. Also consider how the current ratio has changed over time and what that might mean for a company’s trajectory.
- The current ratio is just one of many metrics to consider before buying a stock. To ensure you’re not missing anything, consider hiring a financial advisor. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free matching service matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Capital gains taxes are a part of investing. If you want to see how much you may owe when you sell, use SmartAsset’s free capital gains tax calculator.
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