Many types of financial analysis are conducted using the current ratio. The current ratio is one of the most commonly used measures of the liquidity of a business. It is defined as current assets divided by current liabilities. The formula is:
There are several ways to review the outcome of the current ratio calculation. Consider the following points:
- Trend line. Track the current ratio on a trend line. If the trend is gradually declining, then a company is probably gradually losing its ability to pay off its liabilities. However, this is not necessarily the case. If inventory comprises a large part of current assets, and this element of current assets is declining faster than the overall rate of decline in current assets, the liquidity of the company may actually be improving. The reason is that the remaining components of current assets are more liquid than inventory.
- Component liquidity. As just noted, inventory is not an especially liquid component of current assets. The same concern can be raised with older accounts receivable. Also, that portion of current liabilities related to short-term debts may not be valid, if the debt payments can be postponed. Further, invested funds may not be overly liquid in the short term if the company will experience penalties if it cashes in an investment vehicle. In short, every component on both sides of the current ratio must be examined to determine the extent to which it can be converted to cash or must be paid.
- Line of credit. If a company has a large line of credit, it may have elected to keep no cash on hand, and simply pay for liabilities as they come due by drawing upon the line of credit. This is a financing decision that can yield a low current ratio, and yet the business is always able to meet its payment obligations. In this situation, the outcome of a current ratio measurement is misleading.
In short, a considerable amount of analysis may be necessary to properly interpret the calculation of the current ratio. It is entirely possible that the initial outcome is misleading, and that the actual liquidity of a business is entirely different.