The current ratio as the name suggests has a look at a business’s current
assets versus the value of its current liabilities the reason why it’s called a liquidity ratio is that this ratio is going to examine a business’s ability to cover its short-term debts.
I’m going to talk about ways that you can apply the current ratio to evaluate a firm’s health. The current ratio is a measure of short-term liquidity. When we talk about short-term liquidity what we’re basically trying to determine is whether a firm is in a position to pay its bills, its obligations that it’s going to have in the coming year.
we’re going to have things like accounts receivable, cash, inventory maybe the firm has some kind
of short-term marketable securities. These are the common things that we would find in
current assets and then in current liabilities, the main thing that’s going to stand out is going to
be accounts payable, and then also you’d have as the current portion of long-term
accounts receivable can easily be factored and turned into cash, securities can be easily turned into cash and we’d
like to hope that our inventory can be turned into cash.
let’s say that in terms of current assets firm one has 270 dollars and
then firm 2 has 320 dollars, and then in terms of current liabilities firm
one has 225 dollars in current liabilities and firm 2 has 400. Now we just want to
calculate the current ratio.
assets and divide them by current liabilities. We just take the current assets divided by
the current liabilities and so for firm one I’ve already done the calculation and it’s going to
be 1.2 is the current ratio and then for firm two it’s going to be 0.8, we just take
this 320 and divide it by the 400 and that gives us 0.8.
a higher current ratio for firm 1 so that’s implying the firm one has higher liquidity. Let’s think
about is intuitive so firm 1 actually has more current assets than current liabilities so if we were to subtract, if
we just forgot about computing this ratio for a moment and just set that aside and we subtract the liabilities from
the assets for Firm 1 we would have a positive number, in other words, there are more current
assets than there are current liabilities and that implies that the firm is liquid.
liabilities are more than the current assets so just assuming right now that the firm had to take whatever current
assets it had and try and pay off its current liabilities, firm 2 would be more of a buying potentially than firm
then inventory could be a big question mark. Let’s say there’s a depression or a recession the firm might have
trouble moving some of its inventory and so the inventory might not be that liquid, it might be something we maybe
don’t want to include that in current assets we know that receivables and cash and marketable securities are
liquid but inventory and certain times might not be that liquid in such cases the current ratio might not be the
thing that we want to be looking at would actually look at something called the quick ratio which is what we’re
going to talk about in the next article and it’s something that’s basically the same thing as the current ratio
except it excludes inventory.