What is the Current Ratio?
Buying a stock shouldn't be a random guess at whether a company can make money or sell more widgets or sugar water. Owning a stock is owning a piece of a business. Unless you're gambling with penny stocks, the financial health of the business behind the stock you own is important.
The world of finance has various measurements and statistics for every aspect of a company's performance. They're all intended to provide useful information. Some financial measurements are more enlightening and usable than others.
What is the Current Ratio?
A stock's current ratio is the relationship between the liabilities a business owes and the assets it can use to meet those liabilities. In other words, measures the relationship between the company's debt and its assets.
To calculate a business's current ratio, divide current assets by current liabilities. If Canadian National Lemonade Company has two million dollars worth of assets (cash, lemons and sugar in inventory, and accounts receivable) and one million dollars worth of liabilities (a temporary loan from your Uncle Mike and a bill from a Florida orchard for the lemons), ratio of assets to liabilities is two to one: two million dollars divided by one million dollars.
What Does the Current Ratio Measure?
The current ratio measures the degree to which your company can meet short term debt emergencies. If something awful happened and you had to sell off your assets to pay off every short term debt right now, would you have any cash left over? A healthy company should.
For example, if all of the current liabilities came due right now—if everyone who's given your business a short term loan came to your doorstep right now and demanded a payout—could your business survive? (This may sound like a worst-case scenario, but you'd be surprised. It happens sometime.) The higher the current ratio, the better shape the business is in to weather these short-term liabilities. With a current ratio of 1, you have just enough assets to meet your liabilities. You've broken even. You won't have any spare cash left over, but you won't end up in awful debt. A low current ratio means potential trouble.
This seems straightforward. Yet keep in mind that current liabilities are short term debts; they're liabilities due within a year. This timeline is very important.
The current ratio doesn't measure long-term obligations. If your business borrowed ten million dollars to build a new lemonade factory but you financed that over thirty years, that debt doesn't get counted in the current ratio. (You still have to pay the mortgage every year, but you don't need $10,000,000 on hand right now today to do so.) Your business will remain solvent with regard to the factory loan as long as you can service the debt every month: as long as you make your interest payments.
Similarly, the current ratio concerns itself with all measurable assets, even if you couldn't necessarily sell them at a moment's notice. You may have heard of the quick ratio which measures the relationship of liabilities to liquid assets; that's the subject of a different article, but it represents the real "What if there were a fire sale and the business had to pay off its debts right now?"
What is a Good Current Ratio?
A good current ratio is at least 1. Your business hasn't taken on more short-term obligations than it can afford if everything went wrong tomorrow. An ideal current ratio might approach 2; that's the sign of a very healthy company. While having even more cash on hand is generally better, a business will find diminishing returns from hoarding assets. A business with that much spare cash floating around should pay dividends or buy back stock or otherwise invest it somehow, lest it attract activist investors.
The current ratio doesn't measure a business's cash flow. If you have a low current ratio at the moment but your business brings in a lot of money, your ratio may fluctuate wildly. Similarly if you have to write down accounts receivable, your ratio can decrease.
Rather than assuming that healthy businesses all have current ratios of 2 or higher, it's important to compare the current ratio of companies within the same industry, because they face similar business conditions. An insurance company may have a much higher current ratio than a grocery store (one carries inventory and turns it over often and the other tries to minimize unanticipated payouts).
How to Use the Current Ratio to Analyze Stocks
The best way to use the ratio is as a guidepoint. Why is the current ratio what it is? Is that in line with similar companies? Is it in line with historical trends? Is the ratio artificially high because one company has more inventory than another? Because another company is taking on more short-term financing? Has the current ratio changed suddenly? Is that change positive or negative?
Financial ratios don't tell you whether a business is good or bad. They don't predict whether a business will grow or shrink in the future. They can't tell you whether you should buy a stock—whether the stock price is high, low, or just right. They will help you understand the business, however, and that's one of the most important jobs you have when choosing stocks.
A strong business is worth owning, and a business with a strong current ratio has strengths worth understanding.