Buying a stock shouldn't come from 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 vital to your investing.
The world of finance has various measurements and statistics for every aspect of a company's performance. None of them came from nowhere; each of them measures something specific. Some are useful, because they provide real information you can use right now.
The Current Ratio Compares Debt to Assets
The current ratio is a liquidity ratio representing how well a company can pay off short-term debts with its assets. This ratio is the relationship between the liabilities a business owes and the assets it can use to meet those liabilities.
To calculate a business's current ratio, divide its current assets by its 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), the ratio of assets to liabilities is two to one: two million dollars divided by one million dollars. This gives a current ratio of 2. Remember that number.
With a healthy current ratio, the business can pay off all of its short-term obligations. At a high current ratio of 1 or more, it could pay its current liabilities with cash on hand and other liquid assets and still have enough left over to run the business.
While having plenty of cash on hand is generally good, 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.
What Does the Current Ratio Measure?
The current ratio measures your ability to pay off your short term debts. If something awful happened and you had to sell off your assets to pay off every loan you had due within a year right now, would you have anything 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 demanded a payout—could your business survive? (This may sound like a worst-case scenario, but it happens.) The higher the current ratio, the better shape the business is in to weather these storms. 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. Anything less than 1 means potential trouble.
Keep in mind that current liabilities are short term debts; they're liabilities due within a year. This timeline is very important. Also note that they're not necessarily loans in the sense you might think. If you've purchased 6 million pounds of lemons and have 45 days to pay the invoice, that accounts payable amount counts as a current liability, as would anything you owe to vendors, suppliers, or other creditors. These liabilities are normal for the course of business. (If you read between the lines, you'll realize that the accounts payable you have from other businesses will be current liabilities for them.)
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 by making your monthly 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?"
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—if you can't actually collect everything you're owed—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 but occasionally has to make huge payouts). The nature of the business and its industry determines how you should think about its normal cash flow and its ability to manage emergencies.
What is the Ideal Current Ratio
An ideal current ratio balances between the ability to invest fully in your business and to keep the doors open.
An accountant might tell you that the ideal current ratio is 2—for every $1 of short-term debt, you have $2 of assets. There's wisdom here; you don't want to scramble to meet your obligations in a hurry, and you might not be able to liquidate everything for its full value.
On the other hand, you're balancing the risk of needing to cover your liabilities with the opportunity cost of using the money effectively. Other people can just as well argue that a current ratio of 1.2 is ideal. After all, you've built in your own margin of safety of 20%.
It doesn't matter if you have a trillion dollars of accounts receivable if you can't collect them. Similarly, if you have ten billion dollars in the bank and zero debt and aren't investing in your business to expand and grow, those dollars aren't working very hard for you. Yet keep in mind that this is only one financial metric, and the real danger signs are a current ratio below 1.0 or above 2.0.
How to Use the Current Ratio to Analyze Stocks
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 can help you understand the business, however.
Use this measurement as a guide. 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? If something stands out, why?
A strong business is worth owning, and a business with a good current ratio has strengths worth understanding.
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