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Measuring Liquidity with the Current Ratio

Measuring Liquidity
with the Current Ratio

This video
will focus on understanding whether or not a firm has the ability to meet short
term obligations by way of the current ratio. 
The current ratio is commonly referred to as a liquidity ratio. The
ratio is mainly used to give an idea of a company’s ability to pay back short
term liabilities with short term assets (investopedia,2011).   Understanding the current ratio can give the
sense of efficiency of a company’s operating cycle or its ability to turn it’s
product into cash.

After
watching this video the viewer should be able to understand how to calculate
the current ratio and use the current ratio as another tool to evaluate the
health of a company. This video is intended to explain this simple ratio so
that anybody with little or no knowledge of financial analysis can understand
this easy tool in measuring the short term financial strength of a company.

Video Summary

Any
potential investor may want to get a quick snap shot of a company’s ability to
maintain current operations and fulfill all short term obligations. It is
possible to gather all financial statement of a company and evaluate all the
information to get a full picture of the company’s current financial strength and
ability to satisfy current obligations but, there may be no quicker and easier
way than using the current ratio as an evaluation tool.

The current
ratio is liquidity ratio that measures a company’s ability to meet short term
obligations. The current ratio is equal to current assets divided by current
liabilities. The  higher the ratio, the
more likely the company has the ability to pay off current obligations.

Let’s
understand a few key terms.

Liquidity: The ability to convert assets in to
cash or to obtain cash to meet short term obligations.

-         
A
lack of liquidity may show that a company doesn’t have the ability to meet any
short term obligations and therefore may lack the ability to invest in capital,
ultimately effecting the long term viability of the company.

Current Assets: 
Represent the value of all assets that are reasonably
expected to be converted into cash within one year in the normal course of
business (investopedia,2011).  

-Current assets include cash, accounts receivable,
inventory, marketable securities,

prepaid expenses and other liquid assets that can be
readily converted to cash.


Current liabilities: Obligations on
the balance sheet that are due within one year.

So, lets
calculate the current ratio in an example.

The ABC
company’s current assets are $50,000 and its current liabilities are $40,000
then we would have 50,000 divided by 40,000, which would give us a current
ratio of 1.25.  This means that for every
dollar that ABC company owes in the short term, it has $1.25 in assets that can
be converted into cash in the short term.  

A current
ratio under one suggests that a company would be unable to pay off its obligations
if they came due at this point in time and may have some liquidity issues.

On the other
hand if a company has a very high current ratio, perhaps 3 or 4,  there may be reason for concern because this
may show that a company’s management has so much cash on hand, they may be
doing a poor job investing.

Ultimately,
attempting to analyze a company’s short term financial strength is arguably
best accomplished by using the current ratio as a simple, quick and easy tool.

 

Please
reference the above video at :

http://www.youtube.com/watch?v=7zbe3Ygq400

 

 

 

References:

Wild, J, Subramanyam, K, Halsey, R.
(2007) Financial Statement Analysis. 9th edition, 1221 Avenue of the
Americas, New York, NY 10020: McGraw-Hill Irwin

http://www.investopedia.com/terms/c/currentassets.asp#ixzz1V2zbw2aY

 

http://www.investopedia.com/terms/c/currentratio.asp#axzz1V2cZ3Ubk

 

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