How to calculate the current ratio?
And more importantly, once you have calculated the current ratio,
how to interpret the current ratio?
What does a current ratio of 0.5, 1 or 2 mean?
What is the story behind the numbers?
How are some of the largest companies in the world performing on their current ratio?
Find out all you need to know about the current ratio in this video.
To calculate and interpret the current ratio, we first need to understand its components:
current assets and current liabilities.
Current assets and current liabilities are both groups of accounts on the balance sheet.
A balance sheet is a picture at a point in time (usually the end of the year, or the
end of the quarter) of what a company owns (on the left)
and what a company owes (on the right).
Asset accounts are grouped in either current assets or non-current assets, and liabilities
accounts into current liabilities or non-current liabilities.
Current assets are cash and other assets that are expected
to be converted to cash within a year.
Some examples of accounts in the Current Assets category: Cash, Accounts Receivable, Inventory,
Prepaid Expenses.
Current Liabilities are amounts due to be paid to creditors within twelve months.
Some examples of accounts in the Current Liabilities category: Accounts Payable, Accrued Liabilities,
Short Term Debt.
So the difference between current and non-current assets is whether this asset will be converted
to cash within one year.
The difference between current and non-current liabilities is whether the amounts are due
within one year, or further out.
Once we have found the Current Assets and Current Liabilities numbers on the balance
sheet, we can calculate and then interpret the Current Ratio.
The Current Ratio is simply the amount of Current Assets divided by
the amount of Current Liabilities.
If a company has a Current Ratio of 1, it means that every $ of Current Liabilities
is covered by a $ of Current Assets on the date of the balance sheet.
Remember that the balance sheet is a picture at a point in time.
Based on the transactions and journal entries that happen between this balance sheet and
the next balance sheet, the Current Ratio could move up or down significantly!
Let’s say that on the next balance sheet, that is made one quarter later,
the Current Ratio is 2.
This means that every $ of Current Liabilities is covered by
$2 of Current Assets on the date of the balance sheet.
The opposite could also occur.
Let’s assume the Current Ratio drops to 0.5.
This means that every $ of Current Liabilities is covered by only $0.50 of Current Assets
on the date of the balance sheet.
The Current Ratio is a measure of short term liquidity.
Can the company pays its bills?
Most people (including suppliers and shareholders) would say that
a Current Ratio of 1 or higher is good.
However, is a Current Ratio of 2, 3 or 4 necessarily a good thing?
The ability of a company to pay its bills would be very high,
but a very high Current Ratio could also be a sign that a company
is not putting its cash to much productive use.
Maybe they should invest it in the business (new equipment, or more R&D spending), do
an acquisition, or pay a dividend to its shareholders.
Is a Current Ratio lower than 1 necessarily a bad thing?
The ability of a company to pay its bills might be lower, but a Current Ratio below
1 could also be a sign that a company is very good at managing its working capital: keeping
its receivables and inventory low, and its payables high.
It’s the story behind the ratio and the numbers that is important, and that’s what
we are diving into next.
In preparation for this video, I have read through recent balance sheets of 25 out of
the Dow Jones Industrial Average 30 companies.
I focused on those companies for which Current Ratio is a meaningful metric, which are the
companies outside the financial services industry.
The Current Ratio is both an outcome of how a company is doing financially, as well as
an outcome of choices that a company makes on how to manage its cash.
What I calculated is that the average Current Ratio for these 25 companies based on calendar
year 2017 or fiscal year 2018 ending balance sheets was 1.4.
This means that every $ of Current Liabilities is covered by $1.40 of Current Assets on the
date of the balance sheet.
This is a healthy average Current Ratio, which is not surprising given that many of these
companies are well run and very successful.
My intention was not to find the absolute highest and absolute lowest Current Ratio,
as this might change from balance sheet to balance sheet as time goes by, but rather
to find some companies with an interesting story behind the numbers.
Of the four companies below, which one do you think has a very high Current Ratio?
A: McDonalds (fast food).
B: Microsoft (software).
C: Verizon (telecom).
D: Walmart (retail).
Please vote using the card in the top right of this video.
While you vote, let me clarify that I have used data from the latest annual report at
the time of making the video.
Fiscal year ended December 31, 2017 (for McDonald’s and Verizon), January 31, 2018 (Walmart),
June 30, 2018 (Microsoft).
Let’s review the balance sheets, and calculate the Current Ratios for each of these companies.
McDonald’s.
Current Assets of $5.3 billion on total assets of $33.8 billion, so only 16% of the assets
are in Current Assets.
Within that Current Assets category, cash and equivalents, accounts and notes receivable,
and prepaid expenses and other current assets, are the most sizable numbers.
On the liabilities side, $2.9 billion of Current Liabilities, mostly Accrued Payroll and other
liabilities, and Accounts Payable.
The Current Ratio is 5.3 divided by 2.9 is 1.8.
This means that for McDonald’s every $ of Current Liabilities is covered by $1.80 of
Current Assets on the date of the balance sheet.
Microsoft.
Current Assets of $169.7 billion on total assets of $258.8 billion, so 66% of the assets
are in Current Assets.
Within that Current Assets category, the highly liquid cash, cash equivalents and short-term
investments are the vast majority.
On the liabilities side, $58.5 billion of Current Liabilities, of which $28.9 billion
is in Unearned Revenue (which is revenue for which Microsoft has been paid in advance,
which is yet to be recognized over the multi-year agreement).
The Current Ratio is 169.7 divided by 58.5 is 2.9.
This means that for Microsoft every $ of Current Liabilities is covered by $2.90 of Current
Assets on the date of the balance sheet.
Verizon.
Current Assets of $29.9 billion on total assets of $257.1 billion, so only 12% of the assets
are in Current Assets.
Within that Current Assets category, most of the amount is in Accounts Receivable.
On the liabilities side, $33 billion of Current Liabilities, of which $21.2 billion is in
Accounts Payable.
The Current Ratio is 29.9 divided by 33 is 0.9.
This means that for Verizon every $ of Current Liabilities is covered by $0.90 of Current
Assets on the date of the balance sheet.
Verizon spends a lot of cash every year on Capital Expenditures, dividends, and debt
repayments, so the company has chosen to keep the cash balance in Current Assets very low,
which results in a lower Current Ratio.
Walmart.
Current Assets of $59.7 billion on total assets of $204.5 billion, so 29% of the assets are
in Current Assets.
Within that Current Assets category, Inventories are the vast majority of the balance.
On the liabilities side, $78.5 billion of Current Liabilities, of which more than half
is in Accounts Payable.
The Current Ratio is 59.7 divided by 78.5 is 0.8.
This means that for Walmart every $ of Current Liabilities is covered by $0.80 of Current
Assets on the date of the balance sheet.
This is a typical picture for a retail company: manage your working capital well by keeping
receivables low, and having inventories that are lower than payables.
In summary.
Of the four companies below, which one has a very high Current Ratio?
Microsoft 2.9.
McDonald’s 1.8.
Verizon 0.9.
Walmart 0.8.
The highest of the four for 2017/2018 is Microsoft.
Each company has a different composition of the amounts in Current Assets and Current
Liabilities, and its own story behind the numbers.
I wish you all the best in your own calculation and analysis of Current Ratios.
I hope this explanation and discussion of the Current Ratio was useful for you.
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Thank you.