The current ratio is a cornerstone financial analysis metric widely used to assess a company's short-term financial health. By comparing a company's current assets to its current liabilities, investors can understand whether the business can meet its obligations over the next 12 months. While not a foolproof financial tool, the current ratio helps spot potential turbulence before it impacts the stock price. Keep reading to learn more about the current ratio, its formula, and how to apply it to your due diligence process.
What Is the Current Ratio?
In personal finance, advisors preach the importance of an emergency fund for short-term needs. If you were to lose your job unexpectedly, the emergency fund can help pay the mortgage and buy groceries until you resume working. You can’t live forever off emergency savings but you'll be able to meet short-term liquidity obligations. Companies don’t keep emergency funds like individuals, but if they did, the current ratio would be the financial metric used to evaluate them.
One of the most basic yet essential tools in financial statement analysis, the current ratio measures a company's ability to cover its short-term liabilities with its short-term assets. It assesses a firm’s financial health and creditworthiness and helps benchmark against other industry companies.
To understand how the current ratio works, we must define two critical concepts that are used to calculate the ratio: current assets and current liabilities.
- Current Assets: Short-term assets that can be easily converted into cash, such as capital, receivables, and inventory.
- Current Liabilities: Debt and obligations due within a year, such as short-term loans or accounts payable.
How to Calculate the Current Ratio
Calculating the current ratio isn’t a complicated process. Here’s the basic formula:
Current Ratio = Current Assets / Current Liabilities
That’s it! Divide the company’s short-term assets by its short-term obligations to determine how much liquidity it can produce.
For example, let’s assume after an accounting roundup that Company A has $1.5 million in current assets and $1 million in current liabilities. In this scenario, you divide 1.5 million by 1 million and get 1.5, meaning that Company A has $1.50 in assets for every $1 of liability. A current ratio of 1.5 indicates good liquidity, as the company would only need to liquidate 66% of its short-term assets to meet 100% of short-term obligations.
What Is an Ideal Current Ratio?
Like most investing concepts, the answer depends. Obviously, a positive current ratio is a good sign. However, when a company takes on more debt than it can manage regarding assets, trouble could be ahead, regardless of the industry. A company with a current ratio below 1 has red flag potential, although some businesses, like grocery stores, often drop below 1 without concern.
Generally, a current ratio between 1.5 and 2.0 is considered healthy, but this figure should always be compared with the industry average since certain stock sectors tend to run hot and cold when it comes to current ratios. For example:
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Retail: May operate with a lower ratio due to rapid inventory turnover, although this can vary based on what products the company sells. The easier it is to move the merchandise, the lower the ratio tends to come out.
The key to adequately utilizing the current ratio is to always compare to other similar firms or the industry as a whole. Comparing the current ratio of a tech giant to a wholesale club store would produce some fruitless analysis (as you’ll see below).
Advantages and Limitations of the Current Ratio
The current ratio is a simple and easily digested metric, but investors must factor in its limitations before using it. Here are a few pros and cons to consider when using the current ratio in your stock analysis.
Pros:
- Easy to calculate and compare to competitors
- Provides a quick snapshot of short-term financial health
- Useful for trend analysis over time when compared to competing firms or the industry average
Cons:
- Doesn't account for the liquidity of current assets
- May not reflect seasonal fluctuations in certain industries
- Can be misleading if liabilities are due before assets can be sold or realized
How to Apply the Current Ratio
Here are two examples of the current ratio that highlight its potential use in stock analysis (along with its limitations).
Costco
Costco Wholesale Corp. (NASDAQ: COST) is the top wholesale club retailer in the world, with more members than Sam’s Club and BJ’s combined. It also might be on a firmer financial footing when looking at current ratios. Costco has a current ratio of 0.97, higher than BJ's and Sam’s Club parent-company Walmart. Walmart sells faster-moving inventory so some dropoff is expected, but 0.97 is a good ratio for the retail sector which attempts to keep inventories as liquid as possible.
NVIDIA
On the other hand, a company like NVIDIA Corp (NASDAQ: NVDA) in the tech sector needs to have more cash on hand to fund its short-term liabilities, so it should naturally have a higher current ratio than retailers like Costco and BJ’s. And sure enough, NVIDIA has a (stunning) current ratio of 4.27, dwarfing that of the retail giants. But is this a good ratio compared to its competitors? Rival chipmaker AMD has a 2.50 current ratio, and Intel lags even further behind at 1.31. When comparing current ratios, NVIDIA still looks like a quality stock to buy compared to other rivals in the semiconductor space.
Putting the Current Ratio into Perspective
The current ratio is a valuable tool for assessing a company’s liquidity and overall financial health, but it is not a metric that can be used alone for complete analysis. While it provides a quick snapshot, you must interpret it in the context of the specific industry and alongside other financial metrics.
For example, comparing the current ratio of Costco to NVIDIA in the above example is pointless. But if you compare NVIDIA to its competitors or the semiconductor industry average, you’ll have a more helpful picture of the company’s health. Understanding the current ratio and its implications empowers you to make informed decisions, whether you're investing in stocks or managing your business finances. Just make sure you understand how to use it in context and in conjunction with other metrics. And always consult with an advisor before making any significant changes to your investment portfolio.
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