You sit down with the annual report, spreadsheet ready to see what hidden gold may await. In the Balance Sheet there’s an important measure of liquidity known as the Current Ratio; total current assets divided by total current liabilities. This little gem gives you an idea of whether the business could quickly cover their short-term liabilities with its relatively liquid assets if sales dried up or all debts get called at one time. Theoretically, a current ratio of one or greater is seen as a good news story but a ratio of 1:1, just like love is sometimes not enough.
CURRENT RATIO: CURRENT ASSETS / CURRENT LIABILITIES
First, let’s define the current asset and current liability. These are assets whose value will or can be consumed inside of a twelve-month period and similarly a current liability is one with a due date inside of a twelve-month window. This one-year term often means non-liquid assets (not readily converted to cash) are included such as accounts receivable.
If for some reason all of the current liabilities became due at one time, it is not likely a business will able to convert its accounts receivable into cash to meet a debtor’s demand, nor can they use this asset to pay down debts by transferring the right of collection to a creditor. Depending on their credit terms some businesses may wait more than ninety days to receive cash flow from sales or services rendered. Does the business have the cash to cover the short-term debts without liquidating inventory (stock for sale) or creating further debt? Will it be able to pay its staff? Long-term further borrowing to fund debt is not a smart idea, imagine paying your home loan with your credit card. Credit can be hard to find when you don’t appear to have any money or assets to offer against the debt.
Conclusion: When considering the current ratio, a business with cash and cash equivalents that exceed current liabilities shows more strength than one with a current ratio of 1. Look at what the current assets consist of and whether they are convertible into cash in a hurry. Divide the total of cash and cash equivalents by current liabilities, if the result of this is a number greater than one there is more short-term strength in this business.
This is general information only and does not constitute financial advice, investment in financial assets can cause losses and should be undertaken at your own risk or after seeking professional advice.
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