- author: The Finance Storyteller
How to Calculate and Interpret the Current Ratio
The current ratio is a widely used financial ratio that measures a company's ability to pay its short-term liabilities with its short-term assets. This ratio is essential to investors, creditors, and analysts alike to determine the financial health of a company. In this article, we will discuss how to calculate and interpret the current ratio and explore the story behind the ratio. We will also look at the current ratios of four large corporations and analyze the results.
Understanding Current Assets and Current Liabilities
To calculate and interpret the current ratio, we first need to understand its components: current assets and current liabilities. Current assets and current liabilities are two groups of accounts on the balance sheet, which outlines what a company owns and what it owes.
Asset accounts are categorized into current assets or non-current assets, and liability accounts into current liabilities or non-current liabilities. Current assets are assets that a company expects to convert into cash within a year, whereas current liabilities are amounts due to be paid to creditors within a year.
Some examples of current assets include cash, accounts receivable, inventory, and prepaid expenses. Examples of current liabilities are accounts payable, accrued liabilities, and short-term debt.
Calculating the Current Ratio
The current ratio is calculated by dividing the total current assets by the total current liabilities. A company with a current ratio of 1 indicates that its current assets are sufficient to pay its current liabilities. A current ratio greater than 1 indicates that the company has more current assets than current liabilities, meaning the company has enough liquidity to cover its short-term obligations.
A current ratio less than 1 means that the company's current liabilities exceed its current assets. It is essential to note that different industries and companies have different acceptable current ratio levels. Therefore one must understand the financial position of that particular industry to interpret the current ratio.
The Story Behind the Numbers
It is essential not to take the current ratio at face value and instead examine the story behind the numbers. The Current Ratio is both an outcome of how a company is doing financially and an outcome of choices that a company makes on how to manage its cash. A current ratio greater than 1 does not necessarily imply excellent financial health or liquidity. Some companies may have a low current ratio due to its excellent management of working capital. On the other hand, a high current ratio can indicate that the company is not using its cash productively.
Analyzing the Current Ratios of selected Corporations
Let us look at the current ratios of four corporations and analyze the results. From the Dow Jones Industrial Average 30 companies, we have selected four companies outside the financial services industry since current ratio is not a metric used extensively in the financial sector industry.
Current Assets of $5.3 billion, whereas the Current Liabilities are $2.9 billion. Therefore, the current ratio for McDonald's is 1.8. This amount indicates that for McDonald's, every dollar of current liabilities can be covered by $1.80 of current assets.
Microsoft has Current Assets of $169.7 billion, whereas the Current Liabilities are $58.5 billion, making Microsoft's current ratio 2.9. A high current ratio indicates that Microsoft has enough liquidity to cover its short-term obligations, which can be attributed to the significant cash balances it has on its books.
Current assets for Verizon are $29.9 billion, whereas the Current Liabilities are $33 billion, indicating a current ratio of 0.9. This means that every dollar of current liabilities can be covered by $0.90 of current assets. It is essential to note that Verizon keeps its cash balance in current assets very low, primarily due to significant cash outflow in the form of debt repayments, dividend payments, and capital expenditures.
Walmart's current assets are $59.7 billion, whereas the Current Liabilities are $78.5 billion. Thus the current ratio for Walmart works out to 0.8. This indicates that each dollar of current liabilities is covered by $0.80 of current assets.
The current ratio is a fundamental metric to determine a company's financial health, but it is essential to examine the story behind the numbers. A company with a low current ratio is not necessarily in poor financial health, and high current ratios can indicate poor cash management. By looking at the current ratios of McDonald's, Microsoft, Verizon, and Walmart, we can see the composition of their current assets and liabilities and analyze their financial health.