The Current Ratio What It Means
One of the metrics I like to look at when I assess the financial health of a company is the current ratio. This ratio is calculated by dividing the current assets by the current liabilities.
The current assets consist of cash, receivables, inventories and financial instruments that can be easily turned into cash.
The current liabilities consist of payables, debts, taxes and dividends that are payable within a year.
The purpose of this ratio is to know how capable the company is in paying its obligations when they fall due.
A ratio of below 1 is not a good sign. This does not mean the company will go bankrupt, but it does mean that it may have difficulty settling payments that are due to be paid.
A current ratio of between 2 to 3 is preferable. If the ratio is above 3, it may mean that the company is not competent in using its assets to generate returns.
When you compare current ratio it must be done among companies of the same business to be of any use. Simply put, a higher ratio than 1 is better than a ratio of below 1.
To invest intelligently, you never look at 1 metric alone. There are many other things and metrics to look at. The most common ones are: the calibre of the management, business modal, price-earnings ratio, return on equity, market capitalisation, enterprise value, dividend yield, price to sales ratio, price to book value, acid ratio, return on capital employed, net tangible asset, margins, free cash flow, etc.
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