This time we will try to discuss the current ratio included in accounting knowledge. Company liquidity is the ability of the company to fulfill its financial obligations in the short term, or before the specified maturity.
The liquidity ratio is an effort to measure a company’s ability to pay its short-term debt. This is done by comparing the most liquid company assets (most easily and quickly converted into cash) with short-term liabilities.
In short, the greater the guarantee of ownership of liquid assets and short-term liabilities of a company, the better. Companies that have low guaranteed rates, should make an investor beware because this is a sign the company having difficulties. About how to fulfill the obligation financial short term.
The liquidity ratio is based on several different portions of assets and liabilities owned by the company today (current assets and current liabilities) and can be seen from the company’s balance sheet.
Current ratio formula
The current ratio is used to measure the ability of a company to cover short-term liabilities with assets currently owned.
While the formula for calculating the current ratio is as follows:
Current ratio = Current assets : Current liabilities
Now we try to take an example from Microsoft’s company balance sheet in the last quarter of 2016 as a simulation of calculating this current ratio.
Current Assets Microsoft
Cash and equivalent :$8,468,000
Short-term investment of :$ 114,313,000
Net profit of :$ 14,343,000
inventory :$ 5,864,000
Others :$ 5,864,000
Total current assets of :$ 144,949,000
Current Liabilities Microsoft
Loan to be pay :$ 6,580,000
Short-term debt of :$ 25,065,000
Others :$ 39,142,000
Total current liabilities of :$ 70,787,000
To calculate Microsoft’s current ratio, we use the formula above, by dividing the current assets with current liabilities:
Current ratio = 144,949,000: 70,787,000 = 2.05
Healthy ratio value for the company
This number can give instructions to investors and analysts about the efficiency of the company’s operational cycle, or its ability to assess product exchange rates. The higher the ratio number, the more the company is able to pay its obligations.
The actual acceptable ratio varies and depends on the industry in which the company is engaged. But usually, the ratio numbers from 1.5-3 that considered as healthy numbers.
Investors and analysts will consider Microsoft — with a current ratio of 2.05 — as a financially healthy company and able to pay its obligations.
A ratio below 1 indicates that a company is unable to pay its obligations when it is due. But these figures do not necessarily indicate that a company is on the verge of bankruptcy, because the company may still have other funding sources. But it cannot be denied that the ratio below 1 indicates that the company is not in good financial condition.
Conversely, a ratio that is too high can also indicate that a company is less effective in using current assets or short-term funding.
Other factors that are considered
Indeed, knowing the current ratio and other liquidity ratios can help potential investors to know how healthy the condition of a company is. But they – or the analyst in charge of calculating the current ratio – know and be aware that this figure is not a complete picture of a company’s liquidity. They also need to pay attention to several things, namely:
- The types of current assets owned by the company and how quickly they can be converted into cash are also things that must be considered
- How long does it take for the company to collect payments after a sale has occurred?
- How fast the company’s inventory can be disbursed if there is an urgent need.
- What percentage of the inventory value can be received by the company?
- Calculate the company’s inventory turnover ratio, which is how long it takes the company to sell or change its inventory.
The current ratio is not merely estimating that a company can, and will, liquidate all its current assets and convert them into cash to cover its liabilities. In fact, this is very rare because companies are expected to continue so that a certain level of working capital is still needed.
Companies that appear to have a high current ratio are not necessarily safer than other companies with a low current ratio. As we mentioned above, an analyst must look beyond the current ratio, like composition and quality asset company. The current ratio is only one of the many financial indicators that must be analyzed by potential investors and creditors.
This financial ratio will be more useful if it is used to compare many companies engaged in the same industry, rather than just being used to assess one company. The financial ratio will not effective to use for comparing several different industrial companies.
In essence, investors must also consider more than one number/type of financial ratio when making investment decisions.
because one type is actually less to provide a comprehensive picture of the financial condition of a company.
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