Analyzing companies to invest in their shares involves taking into account many factors – and one of them is the current ratio. As you can understand from the name of the term, the emphasis is on studying the company’s ability to quickly pay off debts and obligations.
What else can this indicator tell you? And how to correctly calculate the current liquidity ratio?
Determination of the current liquidity ratio
This concept in English sounds like “Current Ratio”, but often it is also meant by the definition of “Working Capital Ratio”, which means the coefficient of working, or working capital. So, what is the current ratio? This is an indicator that assesses the ability of the enterprise to repay debts and pay off short-term obligations.
“Short-term” refers to debts and liabilities with maturities of up to 12 months. It is logical to conclude that the current liquidity ratio is also the ratio of funds that are in the company’s turnover to short-term liabilities, or current liabilities.
What does this mean for the investor? By studying this indicator, he evaluates the solvency of the company, as well as the payback and stability of investments in its shares.
The basic formula for calculating the current ratio
Most ratios have several calculation formulas, and the same applies to the current ratio. The calculation formula that is applied in the first place looks like this: CR = CA / CL. CR here is the current ratio, it is the same coveted ratio, CA is the current assets, or the company’s assets, and CL is the current liabilities, or its current liabilities.
Current debts that the company must quickly repay include term loans or loans, accounts payable to suppliers, employees, the owner; reserves for future payments and liabilities intended for sale are taken into account. All these data are included in the analysis required for the current liquidity ratio, which is carried out by the enterprise itself and evaluated by the investor.
How to evaluate the value of the current liquidity ratio?
It is important to understand that the normative value of the indicator depends on the industry in which the enterprise operates. Thus, it is customary to calculate the norm for the current liquidity ratio in the range from 1 to 3. However, it is necessary to take into account the specifics of the companies’ activities:
- An area with high cash flow and frequent short-term borrowing – this includes retail businesses that often borrow large amounts. In their case, a stable current ratio will be 1 or so.
- Industry – this includes enterprises with a large amount of stocks and a long production period. For them, the optimal value is 3 or even higher.
Having understood how the current liquidity ratio works and how it is calculated, it is easy to understand that a value less than 1 will indicate that the company has some difficulties in paying off obligations, and it is dangerous to issue loans to creditors. A value greater than 3 hints at poor asset management.
Often, the company itself includes in the report the indicator of the current liquidity ratio. It is already clear that this is one of the main values, and in the future the investor will be able to effectively evaluate investments in shares using this information.