Company management use different methods of analyzing a business to see if it is performing well. Outsiders will also review and financial statements to see if a company is worthy as an investment.
An easy shorthand is to compare a company over time or against others is by using ratios; that is, comparing one set of numbers against another. One of the most common ratios is the current ratio, which is determined by dividing current assets by current liabilities. The current ratio is a measure of liquidity, how liquid the company is, that is, how able it is to meet short-term expenses.
Definition of Current Assets
Current assets are items that company has ownership of, and expects to expend them in one year or less. Companies expend assets by their use in the business, or by otherwise converting them to cash.
Common current assets are:
- Cash
- Short term investments
- Accounts Receivables
- Inventory
Definition of Current Liabilities
Similarly, current liabilities are those that re expected to be resolved in one year or less. They are generally resolved by the expenditure of cash. Common current liabilities are:
- Accounts payable
- Accrued payroll taxes
- Accrued liabilities
- Short term portion of long term note
Although any item this is expected to be off the books within a year is considered current. This is in contrast to long term items, such as property, plant and equipment, long term investments, or other than the current portion of long term debt.
Computing the Current Ratio
For example, if a company has $20,000 in current assets and $10,000, the current ratio is 2.0. The current ratio will likely vary any time the books are closed, since there will be changes in the components. If there is a substantial change, the accounting should investigate to make sure there is not an error, or to identify the reason for the change.
It is not possible to identify a desired value for the current ratio. Companies vary based on how much cash is required. Anything less than 1.0 is a warning sign, since there may not be enough cash to pay current operations. The company can resolve this issue by generating assets from operations or converting short-term liabilities to long-term debt
The Quick Ratio, also known as The Acid Test Ratio
The Quick Ratio is very similar to the Current Ratio, except that inventory is excluded from current assets in the calculation. This means that any company with inventory, the quick ratio is a smaller number than the current ratio.
The Quick Ratio acts as another indicator of potential financial trouble. A company may have a current ratio of 2.0, indicating a healthy financial position. If the same statement produces a Quick Ratio of 0.5, it means that many current assets are tied up in inventory, which may be harder to convert to cash if the company’s products are not selling.
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