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Liquidity Measurement Ratios: CurrentLiquidity Measurement Ratios: CurrentRatioRatio

By Richard LothBy Richard Loth ((ContactContact | | BiographyBiography))

The The current ratiocurrent ratio is a popular financial ratio used to test a company's is a popular financial ratio used to test a company's liquidityliquidity

(also referred to as its current or (also referred to as its current or working capitalworking capital position) by deriving the position) by deriving the

proportion of current assets available to cover current liabilities.proportion of current assets available to cover current liabilities.

The concept behind this ratio is to ascertain whether a company's short-termThe concept behind this ratio is to ascertain whether a company's short-term

assets (cash, cash equivalents, marketable securities, receivables and inventory)assets (cash, cash equivalents, marketable securities, receivables and inventory)

are readily available to pay off its short-term liabilities (notes payable, currentare readily available to pay off its short-term liabilities (notes payable, current

portion of term debt, payables, accrued expenses and taxes). In theory, theportion of term debt, payables, accrued expenses and taxes). In theory, the

higher the current ratio, the better.higher the current ratio, the better.

FormulaFormula::

Components:Components:

As of December 31, 2005, with amounts expressed in millions, ZimmerAs of December 31, 2005, with amounts expressed in millions, Zimmer

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Liquidity Measurement Ratios: Current RatioLiquidity Measurement Ratios: Current Ratio

2. Liquidity Measurement Ratios:

Current Ratio

3. Liquidity Measurement Ratios: Quick

Ratio

4. Liquidity Measurement Ratios: Cash

Ratio

5. Liquidity Measurement Ratios: Cash

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Holdings' current assets amounted to $1,575.60 (balance sheet), which is theHoldings' current assets amounted to $1,575.60 (balance sheet), which is the

numerator; while current liabilities amounted to $606.90 (balance sheet), whichnumerator; while current liabilities amounted to $606.90 (balance sheet), which

is the denominator. By dividing, the equation gives us a current ratio of 2.6.is the denominator. By dividing, the equation gives us a current ratio of 2.6.

Variations: Variations:

NoneNone

CommentaryCommentary::

The current ratio is used extensively in financial reporting. However, while easyThe current ratio is used extensively in financial reporting. However, while easy

to understand, it can be misleading in both a positive and negative sense - i.e., ato understand, it can be misleading in both a positive and negative sense - i.e., a

high current ratio is not necessarily good, and a low current ratio is nothigh current ratio is not necessarily good, and a low current ratio is not

necessarily bad (see chart below).necessarily bad (see chart below).

Here's why: Contrary to popular perception, the ubiquitous current ratio, as anHere's why: Contrary to popular perception, the ubiquitous current ratio, as an

indicator of liquidity, is flawed because it's conceptually based on the liquidationindicator of liquidity, is flawed because it's conceptually based on the liquidation

of all of a company's current assets to meet all of its current liabilities. In reality,of all of a company's current assets to meet all of its current liabilities. In reality,

this is not likely to occur. Investors have to look at a company as a goingthis is not likely to occur. Investors have to look at a company as a going

concern. It's the time it takes to convert a company's working capital assets intoconcern. It's the time it takes to convert a company's working capital assets into

cash to pay its current obligations that is the key to its liquidity. In a word, thecash to pay its current obligations that is the key to its liquidity. In a word, the

current ratio can be "misleading."current ratio can be "misleading."

A simplistic, but accurate,A simplistic, but accurate,

comparison of two companies'comparison of two companies'

current position will illustrate thecurrent position will illustrate the

weakness of relying on the currentweakness of relying on the current

ratio or a working capital numberratio or a working capital number

(current assets minus current(current assets minus current

liabilities) as a sole indicator ofliabilities) as a sole indicator of

liquidity:liquidity:

---- Company ABCCompany ABC Company XYZCompany XYZ

Current AssetsCurrent Assets $600$600 $300$300

Current LiabilitiesCurrent Liabilities $300$300 $300$300

Working CapitalWorking Capital $300$300 $0$0

Current RatioCurrent Ratio 2.02.0 1.01.0

Company ABC looks like an easy winner in a liquidity contest. It has an ampleCompany ABC looks like an easy winner in a liquidity contest. It has an ample

margin of current assets over current liabilities, a seemingly good current ratio,margin of current assets over current liabilities, a seemingly good current ratio,

and working capital of $300. Company XYZ has no current asset/liabilityand working capital of $300. Company XYZ has no current asset/liability

margin of safety, a weak current ratio, and no working capital.margin of safety, a weak current ratio, and no working capital.

However, to prove the point, what if: (1) both companies' current liabilitiesHowever, to prove the point, what if: (1) both companies' current liabilities

have an average payment period of 30 days; (2) Company ABC needs sixhave an average payment period of 30 days; (2) Company ABC needs six

months (180 days) to collect its account receivables, and its inventory turnsmonths (180 days) to collect its account receivables, and its inventory turns

over just once a year (365 days); and (3) Company XYZ is paid cash by itsover just once a year (365 days); and (3) Company XYZ is paid cash by its

customers, and its inventory turns over 24 times a year (every 15 days). customers, and its inventory turns over 24 times a year (every 15 days).

In this contrived example, Company ABC is very In this contrived example, Company ABC is very illiquid illiquid and would not be ableand would not be able

to operate under the conditions described. Its bills are coming due faster than itsto operate under the conditions described. Its bills are coming due faster than its

generation of cash. You can't pay bills with working capital; you pay bills withgeneration of cash. You can't pay bills with working capital; you pay bills with

cash! Company's XYZ's seemingly tight current position is, in effect, much morecash! Company's XYZ's seemingly tight current position is, in effect, much more

liquid because of its quicker cash conversion. liquid because of its quicker cash conversion.

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Next: Next: Liquidity Measurement Ratios: Quick RatioLiquidity Measurement Ratios: Quick Ratio

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Unaffiliated InvestmentsUnaffiliated InvestmentsStocks, bonds, and other investmentStocks, bonds, and other investmentholdings in companies neither ...holdings in companies neither ...

Overall Liquidity RatioOverall Liquidity RatioA measurement of a company’s capacity toA measurement of a company’s capacity topay for its liabilities ...pay for its liabilities ...

Hard-To-Sell AssetHard-To-Sell AssetAn asset that is extremely difficult toAn asset that is extremely difficult todispose of either due ...dispose of either due ...

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When looking at the current ratio, it is important that a company's currentWhen looking at the current ratio, it is important that a company's current

assets can cover its current liabilities; however, investors should be aware thatassets can cover its current liabilities; however, investors should be aware that

this is not the whole story on company liquidity. Try to understand the types ofthis is not the whole story on company liquidity. Try to understand the types of

current assets the company has and how quickly these can be converted intocurrent assets the company has and how quickly these can be converted into

cash to meet current liabilities. This important perspective can be seen throughcash to meet current liabilities. This important perspective can be seen through

the the cash conversion cyclecash conversion cycle (read the (read the chapter on CCCchapter on CCC now) now). By digging deeper. By digging deeper

into the current assets, you will gain a greater understanding of a company'sinto the current assets, you will gain a greater understanding of a company's

true liquidity.true liquidity.

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Beginning InvestorBeginning Investor Fundamental AnalysisFundamental Analysis LiquidityLiquidity Liquidity RatioLiquidity Ratio

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Q: Q: What is the formula for calculating the current ratio in Excel?What is the formula for calculating the current ratio in Excel?A: A: Understand the basics of the current ratio, including its use and interpretation as aUnderstand the basics of the current ratio, including its use and interpretation as a

2. Liquidity Measurement Ratios:

Current Ratio

3. Liquidity Measurement Ratios: Quick

Ratio

4. Liquidity Measurement Ratios: Cash

Ratio

5. Liquidity Measurement Ratios: Cash

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