Current ratio is one of the most fundamental liquidity ratio. It measures the ability of a business to repay current liabilities with current assets.
Current assets are assets that are expected to be converted to cash within normal operating cycle, or one year. Examples of current assets include cash and cash equivalents, marketable securities, short-term investments, accounts receivable, short-term portion of notes receivable, inventories and short-term prepayments.
Current liabilities are obligations that require settlement within normal operating cycle or next 12 months. Examples of current liabilities include accounts payable, salaries and wages payable, current tax payable, sales tax payable, accrued expenses, etc.
Current ratio is calculated using the following formula:
Companies are required by GAAP to classify assets and liabilities into current and non-current on their balance sheets. This simplifies calculation of current ratio for liquidity analysis. All we need to do is to obtain the current assets and current liabilities figure and divide the former by later.
Where a classified balance sheet (i.e. a balance sheet in to which there is a current and non-current categorization) is not available, we need to analyze the balance sheet line items to identify current assets and current liabilities. Assets and liabilities are listed in the descending order of liquidity, i.e. assets appearing at the top are more liquid than assets at the bottom of the balance sheet.
Current ratio matches current assets with current liabilities and tells us whether the current assets are enough to settle current liabilities. A current ratio of 1 or more means that current assets are more than current liabilities and the company should not face any liquidity problem. A current ratio below 1 means that current liabilities are more than current assets, which may indicate liquidity problems. In general, higher current ratio is better.
A more meaningful liquidity analysis can be conducted by using current ratio in conjunction with other measures such as quick ratio (also called acid-test ratio), cash ratio, receivables turnover ratio, inventory turnover ratio and cash conversion cycle.
Current ratios should be analyzed in the context of relevant industry. Some industries for example retail, have very high current ratios. Others, for example service providers such as accounting firms, have relatively low current ratios because their business model is such that they do not have any significant current assets.
However, there is a limit to the extent to which higher current ratio is a blessing. An abnormally high value of current ratio may indicate existence of idle or underutilized resources in the company. This is because most of the current assets do not earn any return or earn a very low return as compared to long-term projects. A very high current ratio may hurt a company’s profitability and efficiency.
Calculate and analyze current ratios for The Coca Cola Company (NYSE: KO) and PepsiCo. Inc. (NYSE: PEP) based on the information given below:
All amounts are in USD in million.
The following table shows current ratios for both companies for all three years:
We see that PepsiCo. has higher current ratios than Coca Cola in each of the three years which means that PepsiCo is in a better position to meet short-term liabilities with short-term assets. However, current ratios for Coca Cola too have stayed above 1 in all periods, which is not bad.
Both companies experienced improvement in liquidity moving from 2012 to 2013, however this trend reversed in 2014.
Written by Irfanullah Jan