Current Ratio
Hi!
Before this video, you should already understand the words and concepts found in financial
statements.
So, these financial statements are the Balance Sheet and the Income Statement.
So, the topic for this video is Financial Ratio Analysis with the focus on the Current
Ratio.
Remember, you can always go back to MBAbullshit.com.
Let's get down to it.
Now, this video discusses and analyzes the Current Ratio, which is one of my free videos
on liquidity, profitability, and Market Value Ratios, which include these ratios over here.
Okay.
And, after this, you can check out my next videos in MBAbullshit.com such as my Financial
Leverage Ratio Critical Analysis video which includes these ratios over here.
And after that, or same time as that, or even before that, you can also check on my other
video on Financial Ratios with the focus on turnover ratios critical analysis that includes
these ratios over here.
Alright!
So, let's get down to it.
So let's start with a story.
Let's say that ABC Company has $1,000 in current assets, not $1,000 in assets, and $800 in
current liabilities.
Now, just a reminder, what are current assets liabilities?
These are assets or liabilities which will turn into cash within the next 12 months.
So, if it's a current liability, needs to be paid within the next 12 months.
Current assets are assets which you can easily convert into cash within the next 12 months.
So, now what is the Current Ratio?
Well, it's very simple.
Current Ratio is $1,000 divided by $800.
Where did we get this? $1,000 is $1,000 in Current Assets.
And, $800 is the $800 in Current Liabilities.
And the Current Ratio is 1.25.
Now, the more important thing is, this is very easy to compute, "what does this mean?"
What does 1.25 mean?
The current ratio.
Well, it means that the company has 1.25 times the amount of current assets to pay for its
current liabilities.
Or another easier way to understand it, if you don't understand the meaning of 1.25 times,
is that the company has an excess of 25% in current assets to pay for its current liabilities.
It has more than enough current assets to pay for its current liabilities.
As you can see here, these current assets can be used to pay for the current liabilities
over here and the excess of 25%.
So there are 25% more in current assets to pay for its current liabilities.
So, this indicates, I stress the word indicates because it's not 100% sure, that the company
will not have any trouble paying its debt for the next 12 months.
The current assets are more than the current liabilities for the next 12 months.
How much more?
25% more.
So, if the current ratio is higher than 1, why is this good?
Well it's good for creditors, example banks which loan them money, which needs to be paid
back within the next 12 months.
If the current ratio is less than 1, that means negative net worth in capital.
I’d like to use the word threshold.
The current ratio of 1.0 is the threshold, meaning this company is in trouble if the
current ratio is less than 1.0, because then that means that there's not enough assets
to pay for its current liabilities.
Now, you might think that this is good right?
"Oh, current ratio is higher than 1."
But if your current ratio is high, it can also be bad.
Why is it bad?
It may indicate inefficiency in using short term assets.
Now, what do we mean by this?
Well, just imagine that you are a stock holder or a share holder or an owner.
You will want ABC Company to earn you a profit while using as little assets as reasonably
possible, right?
Because if there are excess assets, like in our example, there's a an excess of 25% of
current assets, you want ABC company to either give you back these excess assets to you as
the owner because the company isn't using it anyway.
Or, you would want the company to invest the excess assets in other projects, etc., to
earn more profit.
So a higher current ratio is not always good.
It is only good for creditors.
For owners, it is not necessarily good.
I'm not saying it's bad, well, it can be bad.
Okay.
But as you can see it's more complicated than just saying that the current ratio is better
when it's high or low.
Okay.
Now the opposite is also true.
If the current ratio is lower than 1, why can this be bad?
Well, it's bad for creditors because then that means that they might not be able to
pay back their creditors within the next 12 months.
But if it's lower than 1, can it also be good?
Well, not necessarily.
I think a better word than lower than 1 is if the current ratio is lower, maybe not necessarily
lower than 1, why is this good?
It might indicate efficiency in using short term assets.
Okay, why?
If you're a stock holder or a share holder, you would want ABC Company to earn you a profit
using as little assets as reasonably possible.
Okay.
So, that's it.
Now, what are the flaws in using this ratio?
Well, let's look at flaw number 1.
First, a high current ratio may give a false sense of security to creditors by treating
all current assets and current liabilities equally.
Now what do I mean?
Well, let's look at an example.
Let's say your company has little cash or zero cash but has current assets.
Okay.
In current assets, let's say that your company has accounts receivable worth $105 which will
be collected in the next 11 months.
So this is still a current asset because it's less than 12 months, right?
But, at the same time your company has current liabilities in the form of accounts payable
of only $23, which is much less than $105.
But, this needs to be paid next month, one month from now.
Okay.
Well, if you try to find the current ratio, you'll find that your current ratio is an
ultra healthy 4.57.
It's way, way higher than the threshold of 1.
So, this indicates that your company is very healthy.
But actually, as you can see, next month this company will be toast.
Why?
Well, you have a very high current ratio because you have more than enough current assets to
pay for your current liabilities.
But, these current assets will be turned into cash 11 months from now, which will be too
late to pay for these current liabilities next month.
So your company will be toast.
Okay.
Your company will have a cash flow problem.
And will not be able to pay its debts even if your current ratio is an ultra healthy
4.57.
Okay.
So, that's it.
Now, what's the 2nd flaw of using this ratio?
Remember, a low current ratio supposedly means that your company is at risk.
A low current ratio may give a full sense of danger.
Let's look at an example.
Let's say your company has little or zero cash but has accounts receivable of $105 as
your current assets and current liabilities in the form of accounts payable of $100.
So, it looks like this company has a dangerously low current ratio of 1.05.
So, it's just a little bit above the 1.0 threshold.
And so, this indicates that your company could be toast, could get burned very soon or very
easily.
But, what If your company has a huge and ready line of credit from banks?
Meaning that your company has a contract arrangement with banks that anytime you need cash, a big
amount of cash, the bank will automatically lend it to you, in case you need it.
So, in this case, you will not necessarily be toast because you can always borrow the
cash to pay for current liabilities.
Okay.
So, that's what it means.
Now, how do we analyze this ratio?
Well, in finance, the 2 traditional ways of using financial ratios is using what we call
time series analysis or historical analysis and comparison to the industry.
So, the first one is to compare your current ratio now to the historical current
ratios of your company.
If your current ratio's higher now than last year's, then either you're in a more stable
or less risky debt situation than before or it could mean that you're more inefficient
now than before in managing assets.
Okay, remember, I said, high current ratio can indicate inefficiency because you're using
too much assets.
Okay.
Or it could be both of the above.
If your current ratio is lower now than last year's then either you're in a more risky
debt situation than before or you're more efficient now than before in managing assets
or both of the above.
And, the traditional analysis number 2 is to compare your current ratio to that of companies
in similar industry.
I'd like to stress similar industry because it's normal for companies from different industries
to have very different current ratios.
Okay.
So, if your current ratio is higher than similar companies, then either you're in a more stable
or risky debt situation than them or it could also mean that you're more inefficient than
them in managing assets or both of the above.
If your current ratio is lower than similar companies, then either you're in a more risky
debt situation than them or you're more efficient than them in managing assets or both of the
above.
Okay.
So simple as that.
So, there you have it.
Now, why do I say similar industry?
For example a bank would have a lot of current debt.
Why?
Because they have a lot of depositors and deposits are considered debt.
Alright.
But certain companies, like I don't know a school for example, a university might not
have, or I don't know nowadays with all these overpaid PhD doctors who are famous and stuff.
I don't know.
But certain businesses on the other hand do not have much debt.
And so, therefore, they would have, should I say, a much more conservative current ratio
or current ratio which looks much more conservative or less risky.
Alright!
But actually, like I said, “what matters more is comparing your current ratio of your
company or of one company to current ratios of other companies in similar industry.”
We do not normally compare the current ratios of 2 different companies in different industries.
Alright!
So, there you have it.
Please share us, if you like us, on twitter.
Just look for MBAbullshit.
On facebook, just go to facebook.com/MBAbullshit or for our Youtube links on your emails.
Have a great day and goodbye.
debbierojonan Page 1