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Current Ratio
Description: The current ratio is heavily used by lenders to see if a company has a sufficient level of liquidity to pay its liabilities. A current ratio of 1:1 is considered to be the absolute minimum level of acceptable liquidity, while a ratio closer to 2:1 is preferred. Essentially, the higher the ratio, the better the ability of a company to pay its short-term debts. Conversely, a very low current ratio indicates that it may be difficult for a business to pay off those of its debts coming due in the near future, unless additional funding is provided. Companies reporting a poor current ratio are frequently those that have invested heavily in inventory or accounts receivable that they cannot liquidate in the near future.
Formula: Divide all current assets by all current liabilities. The formula is as follows:
Current Assets
Current Liabilities
Example: A prospective purchaser is interested in the current financial health of the Ginseng Plus retail chain, which sells herbal remedies for common maladies. She obtains the following information about the company for the past three years:
| Year 1 | Year 2 | Year 3 | |
| Current assets | $4,000,000 | $8,200,000 | $11,700,000 |
| Current liabilities | $2,000,000 | $4,825,000 | $9,000,000 |
| Current ratio | 2:1 | 1.7:1 | 1.3:1 |
The rapid increase in the amount of current assets indicates that the retail chain has probably gone through a rapid expansion over the past few years. The sudden jump in current liabilities in the last year is particularly disturbing, and is indicative of the company suddenly being unable to pay its accounts payable, which have correspondingly ballooned. The investor elects to greatly reduce her offer for the company, in light of the likely prospect of an additional cash infusion in order to bring its operations onto an even keel.
Cautions: This measurement can be misleading if a company’s current assets are heavily weighted in favor of inventories, since this current asset can be difficult to liquidate in the short term. The presence of this problem can be revealed by using the inventory turnover ratio.
The current ratio can be unusually high if a company uses an aggressive cost capitalization approach when costing its inventory. In these instances, a company will add all possible costs to its cost allocation pools, and then use allocation methods that tend to charge the highest possible amounts of these costs to inventory. This problem can be spotted by watching the inventory turnover level on a trend line, to see if the valuation spikes and then remains at the higher level.
Another problem is that the current ratio will look abnormally low for those companies that are drawing down cash from a line of credit, since they will tend to keep cash balances at a minimum, and only replenish their cash when it is absolutely required to pay for liabilities. In these cases, a current ratio of 1:1 or less is common, even though the presence of the line of credit makes it very unlikely that there will be a problem with the payment of liabilities.
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