Current ratio explained

How to calculate the current ratio? And more importantly, once you have calculated the current ratio, how to interpret the current ratio? What does a #currentratio of 0.5, 1 or 2 mean? What is the story behind the numbers? How are some of the largest companies in the world performing on their current ratio? Find out all you need to know about the current ratio in this video. The current ratio is a key metric in #financialratioanalysis

⏱️TIMESTAMPS⏱️
00:00 Current ratio introduction
00:28 Current assets and current liabilities
01:44 Current ratio calculation
02:51 Current ratio interpretation
03:58 Current ratio examples
09:36 Current ratio benchmarking

How to calculate the current ratio? And more importantly, once you have calculated the current ratio, how to interpret the current ratio? What does a #currentratio of 0.5, 1 or 2 mean? What is the story behind the numbers? How are some of the largest companies in the world performing on their current ratio?

To calculate and interpret the current ratio, we first need to understand its components: current assets and current liabilities. Current assets and current liabilities are both groups of accounts on the balance sheet. A balance sheet is a picture at a point in time (usually the end of the year, or the end of the quarter) of what a company owns (on the left) and what a company owes (on the right). Asset accounts are grouped in either current assets or non-current assets, and liabilities accounts into current liabilities or non-current liabilities. Current assets are cash and other assets that are expected to be converted to cash within a year. Some examples of accounts in the Current Assets category: Cash, Accounts Receivable, Inventory, Prepaid Expenses. Current Liabilities are amounts due to be paid to creditors within twelve months. Some examples of accounts in the Current Liabilities category: Accounts Payable, Accrued Liabilities, Short Term Debt. So the difference between current and non-current assets is whether this asset will be converted to cash within one year. The difference between current and non-current liabilities is whether the amounts are due within one year, or further out.

Once we have found the Current Assets and Current Liabilities numbers on the balance sheet, we can calculate and then interpret the Current Ratio. The Current Ratio is simply the amount of Current Assets divided by the amount of Current Liabilities. If a company has a Current Ratio of 1, it means that every $ of Current Liabilities is covered by a $ of Current Assets on the date of the balance sheet. Remember that the balance sheet is a picture at a point in time. Based on the transactions and journal entries that happen between this balance sheet and the next balance sheet, the Current Ratio could move up or down significantly! Let’s say that on the next balance sheet, that is made one quarter later, the Current Ratio is 2. This means that every $ of Current Liabilities is covered by $2 of Current Assets on the date of the balance sheet. The opposite could also occur. Let’s assume the Current Ratio drops to 0.5. This means that every $ of Current Liabilities is covered by only $0.50 of Current Assets on the date of the balance sheet. The Current Ratio is a measure of short term liquidity. Can the company pays its bills? Most people (including suppliers and shareholders) would say that a Current Ratio of 1 or higher is good. However, is a Current Ratio of 2, 3 or 4 necessarily a good thing? The ability of a company to pay its bills would be very high, but a very high Current Ratio could also be a sign that a company is not putting its cash to much productive use. Maybe they should invest it in the business (new equipment, or more R&D spending), do an acquisition, or pay a dividend to its shareholders. Is a Current Ratio lower than 1 necessarily a bad thing? The ability of a company to pay its bills might be lower, but a Current Ratio below 1 could also be a sign that a company is very good at managing its working capital: keeping its receivables and inventory low, and its payables high. It’s the story behind the ratio and the numbers that is important.

Philip de Vroe (The Finance Storyteller) aims to make strategy, finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better stock market investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!