A current ratio reflects liquidity, or the ability of a company to pay its debts in the short term. Learn how to compute a current ratio.
- An important concern about any company is its liquidity, or ability to pay its debts in the short run. If a firm can't meet its obligations in the short run, it may not survive to enjoy the long run. The most commonly used measure of liquidity is the current ratio, which is a comparison of current assets with current liabilities. And let me remind you of what a current asset is and what a current liability is. A current asset is an asset expected to be used or turned into cash within one year.
So, for example, accounts receivable. That's a current asset because we expect those accounts to be collected in cash within one year. Inventory's a current asset because we expect that inventory to be sold and then the cash collected all within one year. Land is not typically a current asset because if we come back a year from now, we expect that land to still be here. Cash is the best current asset because it's already cash. So, our current assets are the liquid assets, the ones that we expect to become cash soon, in less than one year.
Similarly, current liabilities are those liabilities that we expect to have to pay within one year. Accounts payable is a good example of a current liability. We're going to pay our suppliers what we owe them within one 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 know we're going to have to pay within one year, and we like to see a bit of a cushion there. The current ratio is computed by dividing total current assets by total current liabilities.
For Microsoft, the current ratio of 2.4 is computed as follows. Historically, the rule of thumb has been that a current ratio below two suggests the possibility of liquidity problems; however, advances in information technology have enabled companies to be much more effective in minimizing the need to hold cash, inventories, and other current assets. As a result, current ratios for successful companies these days are frequently less than one is seen here.
As you can easily see, there are industry differences when it comes to the current ratio. Airlines tend to have a current ratio less than one, as do cereal companies. Fast food companies tend to cluster as well. Industries in general tend to cluster, and that makes some sense. Companies that do the same thing should kind of look alike. Now, as you might imagine, banks like to see higher current ratios. In fact, 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, for example, 1.5 or above two, and if you fall below two, the bank will start to get nervous.
Maybe you're not going to be able to pay us when you're supposed to pay us, and so your loan's going to be in default. A rule of thumb you will often hear is that the current ratio should be greater than two. 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. They don't need to have as much extra inventory lying around any more.
Cash can be managed much more tightly. Accounts receivable can be tracked more precisely. So, in recent years, current ratios have fallen. In fact, many very safe, financially safe companies have current ratios less than two. That's normal these days. So, the old rule of thumb, the rule that your mom and dad learned when they went to school was current ratios should be about two. Well, current ratios are often less than two now. In general, remember that the current ratio reflects liquidity, the ability of a company to pay its debt in the short term, and we like to see that steady.
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