Thursday, January 24, 2013

Current Ratio

The current ratio simply tells you how much liquidity a firm has - in other words, how much cash it could raise if it absolutely had to pay off its liabilities all at once. A low ratio means the company may not be able to source enough cash to meet near-term liabilities, which would force it to seek outside financing or to divert operating income to pay off those liabilities.

Current Ratio

Rough benchmarks for evaluating a stock's Current Ratio

As a very general rule, a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble. However when you find a company with current ratios of 3 or 4, you may want to be concerned. A number this high might also mean that management has so much cash on hand, they may be doing a poor job of investing it. It is always useful to compare companies within the same industry therefore, to get a better picture.

Unfortunately, some current assets - such as inventories - may be worth less than their value on the balance sheet. (Imagine trying to sell old PCs or last year's fashions to generate cash - you would be unlikely to receive anything close to what you paid for them).

If you see ratios around or below 1, should only be for companies those have inventories that can immediately be converted into cash (e.g. McDonalds). If this is not the case and a company's number is low, that would be cause for concern.

Because of the general illiquid nature of inventories, there's an even more conservative test of a company's liquidity, the Quick Ratio