Learn how to compute the current ratio.
- Step one in a financial analysis is computing return on equity. And then the DuPont framework analysis looks at profitability, efficiency and leverage components. We're now going to be exposed to some additional, powerful ratios. These ratios tell us a lot about a company by applying just a little effort. First we'll look at current ratio. Which is one of the top five ratios of all time. Then the debt ratio, debt-to-equity ratio and then the price-earnings ratio. Let's start with the current ratio. Current ratio is a measure of liquidity. Liquidity reflects the ability of a company to pay it's obligations in the short term. By short term we're typically meaning less than one year. Current ratio is computed as current assets, divided by current liabilities. Let me remind you what a current asset is and what a current liability is. A current asset is an asset expect to be used or turned into cash within one year. For example, inventory is a current asset because we expect that inventory to be sold and then the cash collected all within one year. Land is a not a current asset, typically, because if we come back a year from now we expect that land to still be there. Cash is a also a great current asset because it's already cash. So our current assets are the liquid assets, the one's that we expect to become cash soon, in less than a year. Similarly, current liabilities are the liabilities that we expect to pay within one year. Accounts payable is a good example of a current liability. We're going to pay our suppliers that we owe within a year. So the current ratio reflects the balance between the assets that we have that are going to become cash within one year and the liabilities that we have that we're going to have to pay with cash within one year. And we typically like to see a bit of a cush in there. Let's take a look at current ratios for two retail clothing chains. The current ratio for Nordstrom is 1.1 in 2018. For Dillard's it's over 1.7. So good or bad? 1.7 is certainly bigger than 1.1 but is 1.7 too high or is 1.1 too low? The numbers themselves don't mean much, we need context. Dillard's current ratio in 2017 was 1.9 and it has dropped to 1.7. Nordstrom's was 1.1 in both 2017 and 2018. So Nordstrom's current ratio has remained constant and Dillard's is dropping to look more like Nordstrom. Probably not surprising that ratios for companies in the same industry tend to converge. That makes sense. Tech companies, for example, have similar current ratios. Though much higher than companies in the retail clothing space. Now, what is a current ratio used for? It's very common in bank loan contracts that a bank will say to a borrower, your current ratio has to stay above a certain level. Above 1.1 or above 1.5, for example. Now if your current ratio falls below one, for example, we start to get nervous as a bank. Maybe you're not going to be able to pay us when you're supposed to. And so your loan will go into default. An old rule of thumb was the current ratio should be greater than 2. That's an old rule of thumb. In the new world that we have now, the technology world, companies are able to manage their current assets much more efficiently. Companies don't need as much inventory as they used to need because their information systems can track their inventory very carefully and so companies don't need to have as much extra inventory laying around. Cash can be managed more tightly. Accounts receivable can be tracked more precisely. So in recent years, current ratios have slipped below two. In general, remember that the current ratio reflects liquidity. The ability of a company to pay it's debt in the short term. And we like to see that steady. If that starts to slip in any given company, we start to get nervous about the company's ability to pay it's debts in the short term.
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