Current Ratio
The current ratio
is mainly used to understand
a company's liquidity, its
ability to pay the current
liabilities (debt and
payables) with its current
assets (cash, inventory,
receivables,
prepaid
expenses, etc). The higher
the current ratio, the more
capable the company is of
paying its obligations - at
least in theory. A ratio
under 1:1 indicates that a
company's current
liabilities exceed the
current assets and the
ability to pay its
obligations when they come
due may be impaired. While
this shows the company is
not in good financial
health, other factors such
as profitability, quality of
revenue etc should be
factored in. The current ratio can give a
sense of the efficiency of a
company's operating cycle or
its ability to turn its
product into cash. Companies
that have trouble converting
accounts receivables to cash
or have long inventory
turnover cycles can run into
liquidity problems. Because
business operations differ
in each industry, it is
always more useful to
compare companies within the
same industry.
The formula for current ratio is:
Current ratio =
current assets / current
liabilities
Many lending
institutions and financing
facilities like to use
the current ratio as one of
the covenants that need to
be maintained.
Example:
Google Inc
Fiscal periods ended
12/31/05
12/31/06
9/30/07
<--------In Millions of
Dollars------->
Current assets
$9,001
$13,039
$15,734
Current liabilities
745
1,304
1,783
Current ratio
12:1
10:1
9:1
As can be seen, Google
continued maintains a
healthy current ratio over the
period analyzed - although
it is on a decreasing trend.
Compare this to the net
working capital which
continues to increase!!
This ratio is similar to the
acid-test ratio except that
the acid-test ratio does not
include inventory and
prepaid expenses in the
formula. The components of
current ratio (current
assets and current
liabilities) can be used to
derive
net working capital.