How do you know if a company is able to meet its short term financial obligations?
Current ratio analysis aims to answer this question by considering the current assets of the company with its current liabilities. The basic premise being, if the company has enough current assets, i.e. the assets that can easily be converted to cash in the short term, to be able to meet its short term liabilities (liabilities due within the next 1 year), then the business is liquid enough and is unlikely to have a short term cash shortfall.
Current Ratio Formula
Current Ratio = (Current Assets / Current Liabilities)
Current Assets and Current Liabilities are taken from the balance sheet of the company and represent the availability and need for cash in the short term (1 year or less). Current assets can be either cash or assets that can quickly be converted to cash and are generally carried on the books at the values close to the market value. Current liabilities include short term debt, wages payable, accounts payables and the current portion of long term debt.
Interpretation of Current Ratio for Evaluating Stocks
It is not very rare to find companies that are profitable but they still end up with problems meeting their obligations. If the cash inflows are not timed properly to support the cash outflows, a liquidity crisis or cash crunch can occur.
As investors, one easy way to guard against this potential issue is to look for stocks whose current accounts are fairly liquid. Generally, a Current Ratio greater than 1 indicates there are sufficient short term assets to cover all short term liabilities. Higher the current ratio, more secure is the liquidity of the company.
I generally like to see a company operating with a current ratio of 1.5 to 3. If the current ratio is too high, I would take it to mean that the company management is not very skilled at reinvesting the assets to grow the company or are not interested in returning value to the shareholders (if such growth opportunities are scarce).
I would normally not consider a company operating with a current ratio of less than 1. It is however important to keep in mind that there are situations where a business may run comfortably with a current ratio less than 1, if the speed at which cash flows in is faster than the speed at which the cash flows out. For example, if the inventory turns over quickly (and the company is profitable or has a positive gross margin) and that company can take a longer time to pay the suppliers for the inventory, a current ratio of less than 1 can be supported.
See also: Average Collection Period
In majority of the cases though, it is almost always wise to insist on a current ratio between 1.5 and 3. This should not be a basis to select a stock for investment, but it should always be one of the checks you make before you invest to ensure that there are no hidden issues that you have missed out while doing your due diligence. Most of the time there will not be a problem, but on the rare occasions when there is a problem, the result can be a quick march towards bankruptcy.