Current ratio is one of the many financial ratios used for measuring the financial stability of companies. The main indication of this ratio is whether the company has enough resources (assets) to pay its liabilities over the next twelve months.
This ratio measures the company’s ability to pay back its short term liabilities with its short term assets. The current ratio is calculated as;
Current Ratio = Current Assets/Current Liabilities
Therefore, higher the current ratio, a company is more capable of paying off its liabilities. As an example, the company ‘ABC’ has current assets of $50,000 and it has current liabilities of $25,000. Then ABC’s current ratio will be 2 and it means that for every dollar the company owes, it has $2 available in current assets.
A decline in current ratios warns against increase in short term debts or decrease in assets. This is something that investors need to be aware of. Regardless of any other issue, a declined trend of current ratio means a reduced ability to generate cash.
If a company looks forward to its IPO (Initial Public Offering), many State Securities Bureaus in the US will require that the company has a current ratio of 2 or more. So what does this current ratio say to investors who are looking to buy shares? If you are planning to invest on shares, current ratio and its trend for at least one year needs to be analyzed. If the current ratio has been steady for all this time and now it is going down, that may indicate a recent problem of the firm or some economical impact resulting from share market collapse.
If the current ratio is declining for the past one year, then that company may have a permanent problem such as a bad marketing strategy or bad management. Investors need to be very careful with a company with such trends as it is a clear sign of declination. Therefore, it is best for all investors to always look at a steady or increasing current ratio before investing their money.