Investors and analysts use certain accounting measures in measuring the risk of companies. Financial statements are sometimes convoluted, or even too in depth for basic research. For this reason, certain measures, such as the current ratio exist.
What Is The Current Ratio?
The current ratio is a measurement showing a company’s ability to meet its debts. The definition of the gauge is as follows.
Current Ratio = Current Assets / Current Liabilities
Additionally, current assets include both liquid and illiquid assets. it is essentially a measure of liquidity of a company. For example, if a company shows a current ratio of 2, this means they have 2 times the amount of current assets for each of its current liabilities. It is important to note that this includes all current assets and liabilities.
Explaining The Current Ratio
This ratio helps interested parties understand a company’s solvency position at any given time. Furthermore, some analysts consider companies with a current ratio less than 1 to pose liquidity concerns. Also, the current ratio gives insight into a company’s ability to turn product sales into usable cash. For example, if a company is not efficient at collecting on its accounts receivable, this may pose liquidity problems as it is not a sustainable position.
However, as with most financial measurements, interpretation of this measure is industry specific. Some industries require quick inventory turn over, which decreases the current ratio. This is not a sign of solvency concerns, rather a reality of operating in a space.
Who Uses The Current Ratio?
We mentioned that analysts and investors have interest in company solvency. Additionally, creditors or lenders become familiar with their borrowers liquidity. This ratio serves as a baseline for lending decisions, as it gives a high level view of a companies solvency.
The current ratio is a widely-accepted measure for analyzing alike companies and their financial position. Analysts use it to filter out weak companies, and lenders use it to weigh risks of loans. Becoming familiar with this metric will only boost one’s knowledge of fundamental company analysis.