The current ratio is a liquidity ratio. Liquidity ratios look at the relationship between what a company owes right now – its current liabilities – and what it owns right now – its current assets. Current assets include cash instruments, marketable securities, inventory, and accounts receivables.
The formula for the Current Ratio is as follows:
Current Assets / Current Liabilities.
With liquidity ratios, higher numbers represent safer financial cushions against economic shocks. A company with a high current ratio should have no trouble meeting its short-term debt obligations without sacrificing operational capability.
However, taking the Current Ratio at face value without considering the nature of the company’s assets can lead to trouble. This ratio assumes an easy conversion of an asset into cash, which is not always the case. You need to know how quickly the company collects its receivables and how frequently it turns its inventory.
In summary, few things can drive an investment into the ground quicker than the company’s debt and its ability to manage debt. While they do not provide a magical answer, Liquidity Ratios can help you identify shares that pose less risk..
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