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The current ratio is mainly used to understand a company's liquidity, its ability to pay the current liabilities (debt and payables) with its current assets (cash, inventory, receivables, prepaid expenses, etc). The higher the current ratio, the more capable the company is of paying its obligations - at least in theory. A ratio under 1:1 indicates that a company's current liabilities exceed the current assets and the ability to pay its obligations when they come due may be impaired. While this shows the company is not in good financial health, other factors such as profitability, quality of revenue etc should be factored in.
The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. Companies that have trouble converting accounts receivables to cash or have long inventory turnover cycles can run into liquidity problems. Because business operations differ in each industry, it is always more useful to compare companies within the same industry.The formula for current ratio is:
Current ratio = current assets / current liabilities
Many lending institutions and financing facilities like to use the current ratio as one of the covenants that need to be maintained.
Example:
Google Inc
Fiscal periods ended 12/31/05 12/31/06 9/30/07
<--------In Millions of Dollars------->
Current assets $9,001 $13,039 $15,734
Current liabilities 745 1,304 1,783
Current ratio 12:1 10:1 9:1
As can be seen, Google continued maintains a healthy current ratio over the period analyzed - although it is on a decreasing trend. Compare this to the net working capital which continues to increase!!
This ratio is similar to the acid-test ratio except that the acid-test ratio does not include inventory and prepaid expenses in the formula. The components of current ratio (current assets and current liabilities) can be used to derive net working capital.
