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Website Content
Innerworth.com
Fundamental Analysis -- Financial Ratios
During the Dot-Com boom years I wrote content for various websites, including Innerworth.com. For this investment site I created materials that helped subscribers use fundamental analysis to make investment decisions. I explained investment strategies, like Dogs of the Dow; I described key government stats, like the CPI; and I wrote overviews of major market sectors. I also created a section that showed investors how to compute key financial ratios (like the current ratio) from a company's statements and described what those ratios mean.
CURRENT RATIO (Current Assets ÷ Current Liabilities)
The current ratio is a measure of a company's financial health and its ability to pay its bills. Current assets are the firm's most liquid assets -- they are assets that are either cash or can be converted to cash within one year. Current liabilities are obligations -- accounts payable, wages, etc. -- that are due within one year or less.
So the current ratio calculates how many times short-term assets cover short-term liabilities. It tells you how much breathing room the firm has for keeping its creditors happy in case of unpleasant surprises -- eg, slower sales, higher-than-anticipated bad debts, or unexpected expenses.
The traditional rule of thumb is that the current ratio should be at least 2:1. But it's a rule meant to be broken. First, some analysts suggest a lower standard of 1.5 or greater. Second, the adequacy of a firm's current ratio can only be assessed in light of its business environment. Companies operating in stable industries with stable customers can afford to have lower ratios. Industry practices are also key: if a company is in a business where customers pay immediately but the bills don't come due for 90 days, a current ratio of 1:1 or even less may be OK.
One good way to use a company's current ratio is to compare it with its peers. Its ratio shouldn't be too far out of line with other companies in the industry. Also, the current ratio should be tracked over time to find clues about possible deterioration in the company's business.
Finally, note that a current ratio can be too high. That would indicate a company that's overly conservative with diminished earning power. Again, depending on the industry, companies should be investing their assets in long-term uses like capital equipment to generate high returns, rather than keeping large cash hoards or letting inventory accumulate (inventories are current assets, since they should be converted to cash in one year).
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