Tuesday, 17 January 2012

Current Ratio Analysis

Current Ratio Definition:
Current ratio, defined also as the working capital ratio, reveals company's ability to meet its short-term maturing obligations. Values for the current ratio vary by company and industry. In theory, the larger the ratio is, the more liquid the business is. However, comparing to the industry average is a better way to judge the performance. Current ratio, quick ratio, and other terms are common measurements of cash in a company.

Current Ratio Explanation:
Current ratios are commonly explained as a measure of a company's ability to pay the current debt liabilities. For the lenders, current ratio is very helpful for them to determine whether a company has a sufficient level of liquidity to pay liabilities. They would prefer a high current ratio since it reduces their risk. For the shareholders, current ratio is also important to them to discover the weakness in the financial position of a business. They would prefer a lower current ratio so that more of the company’s assets can be used for growing business. Although current ratio is an indicator of liquidity, investors should be aware that it can not give us the comprehensive information about company’s liquidity. Every industry has its own norms of current ratio. The better way to evaluate it is to check a company’s current ratio against its industry average. More importantly, investors should look at the trend of the current ratio of the company, types of current assets the company has and how quickly these can be converted into cash to meet company’s current liabilities.

Current Ratio Formula:The current ratio formula is: Current ratio = Current assets / Current liabilities

Current Ratio Calculation:
Current assets , when calculated dilligently, represent cash and other assets that will be converted into cash within one year. It normally included cash, marketable securities, accounts receivable and inventories.

Current liabilities represent financial obligations that come due within one year. It normally included accounts payable, notes payable, short-term loans, current portion of term debt, accrued expenses and taxes.

Example: a business has $5,000 in current assets and $2,500 in current liabilities. Current ratio = 5,000 / 2,500 = 2 This means that for every dollar in current liabilities, there is $2 in current assets.

Current Ratio Example:
Desmond has started a scrap metal recycling company called Scrapco. Desmond has made a comfortable living for himself by conducting business with accountability and professionalism in an industry where this is not always the case. Recently, the scrap metal market has experienced some distress and prices have varied much more than before. This has caused his cash stockpiles to vary within the market. As a result, Desmond is worried that he may not be able to meet obligations on the debt financing he has taken for his company equipment, mainly processing machines for the commodities he recieves from individuals to put onto the market.

Desmond decides to do a little research and finds out that this issue is a financial ratio called "current ratio". He then extends his research to using search engines for the keyword "current ratio calculator". Unsatisfied with the outcome, Desmond speaks to his accountant. His accountant performs the current ratio calculation below:

Current Assets = $5,000
Current Liabilities = $2,500

Current ratio = 5,000 / 2,500 = 2

This means that for every dollar in current liabilities, there is $2 in current assets.

Desmond is happy to hear that he has little to worry about. He would like to increase his current ratio but is comforted by where Scrapco stands. Desmond knows that lack of cash is one of the main reasons why businesses fail and resolves to decrease unnecessary expenditures and pay more attention to his cash holdings.


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