Current Ratio
The current ratio is a liquidity and efficiency ratio that measures a
firm’s ability to pay off its short-term liabilities with its current
assets. The current ratio is an important measure of liquidity
because short-term liabilities are due within the next year.
This means that a company has a limited amount of time in order to
raise the funds to pay for these liabilities. Current assets like cash,
cash equivalents, and marketable securities can easily be converted
into cash in the short term. This means that companies with larger
amounts of current assets will more easily be able to pay off
current liabilities when they become due without having to sell off
long-term, revenue generating assets.
ANALYSIS
The current ratio is a liquidity and efficiency ratio that measures a
firm’s ability to pay off its short-term liabilities with its current
assets. The current ratio is an important measure of liquidity
because short-term liabilities are due within the next year.
This means that a company has a limited amount of time in order to
raise the funds to pay for these liabilities. Current assets like cash,
cash equivalents, and marketable securities can easily be converted
into cash in the short term. This means that companies with larger
amounts of current assets will more easily be able to pay off
current liabilities when they become due without having to sell off
long-term, revenue generating assets.
KEY TAKEAWAYS
The current ratio compares all of a company’s current
assets to its current liabilities. These are usually defined as
assets that are cash or will be turned into cash in a year or
less, and liabilities that will be paid in a year or less.
The current ratio is sometimes referred to as the “working
capital” ratio and helps investors understand more about a
company’s ability to cover its short-term debt with its
current assets.
Weaknesses of the current ratio include the difficulty of
comparing the measure across industry groups,
overgeneralization of the specific asset and liability
balances, and the lack of trending information.
Interpreting the Current Ratio
A ratio under 1 indicates that the company’s debts due in a
year or less are greater than its assets (cash or other short-
term assets expected to be converted to cash within a year
or less.)
On the other hand, in theory, the higher the current ratio,
the more capable a company is of paying its obligations
because it has a larger proportion of short-term
asset value relative to the value of its short-term liabilities.
However, while a high ratio, say over 3, could indicate the
company can cover its current liabilities three times, it may
indicate that it's not using its current assets efficiently, is
not securing financing very well, or is not managing its
working capital.
Acid-Test Ratio
The acid-test ratio uses a firm's balance sheet data as an indicator
of whether it has sufficient short-term assets to cover its short-term
liabilities. This metric is more useful in certain situations than the
current ratio, also known as the working capital ratio, since it
ignores assets such as inventory, which may be difficult to quickly
liquidate. The acid-test ratio is also commonly known as the quick
ratio.
KEY TAKEAWAYS
The acid-test, or quick ratio, compares a company's most
short-term assets to its most short-term liabilities to see if
a company has enough cash to pay its immediate liabilities,
such as short-term debt.
The acid-test ratio disregards current assets that are
difficult to liquidate quickly such as inventory.
The acid-test ratio may not give a reliable picture of a
firm's financial condition if the company has accounts
receivable that take longer than usual to collect or current
liabilities that are due but have no immediate payment
needed.
The acid-test ratio involves assessing a company's balance
sheet to see whether it has enough funding on hand to
cover its current debt.
It is seen as more useful than the often-used current ratio
since the acid-test excludes inventory, which can be hard
to quickly liquidate.
In the best-case scenario, a company should have a ratio of
1 or more, suggesting the company has enough cash to
pay its bills.
Too low a ratio can suggest a company is cash-strapped,
but in some cases, it just means a company is dependent
on inventory, like retailers.
Too high a ratio could mean a company is sitting on cash,
but in some cases, that's just industry-specific, like with
some tech companies.
The minimum acid-test ratio a company should have. Firms with a ratio
of less than 1 are short on liquid assets to pay their current debt
obligations or bills and should, therefore, be treated with caution.
Inventory Turnover Ratio
Inventory turnover is the number of times a company sells and
replaces its stock of goods during a period. Inventory turnover
provides insight as to how the company manages costs and how
effective their sales efforts have been.
The higher the inventory turnover, the better since a high
inventory turnover typically means a company is selling
goods very quickly and that demand for their product
exists.
Low inventory turnover, on the other hand, would likely
indicate weaker sales and declining demand for a
company’s products.
Inventory turnover provides insight as to whether a
company is managing its stock properly. The company may
have overestimated demand for their products and
purchased too many goods as shown by low turnover.
Conversely, if inventory turnover is very high, they might
