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What is current ratio, and why does it matter to investors?

10/08/2023

There are many methods that investors use when they’re deciding which companies to invest in. For some, it’s as simple as following tips they’ve seen on social media or gleaned from their contacts, or choosing businesses that they have an attachment to (known as “emotional investing”). Some, on the other hand, spend a great deal of time researching businesses – both before they invest and regularly once they’ve invested – to decide how they manage that investment. 

They’ll read stories – both positive and negative – that the media posts about the business. They’ll scour annual reports. They’ll look at past performance, as well as predictors of future performance. 

One of the metrics that investors may look at is current ratio. Read on for an explanation of what this is, and why it’s an important metric to consider.

 

What is current ratio?

Current ratio is a metric that gives an idea of a company’s financial health. It is calculated by comparing its current assets to its current liabilities, giving an idea of how easily the company is able to pay off its short-term debt. 

A ratio of less than 1 means that the firm has more liabilities than assets. A ratio of more than 1 means that it has more assets than liabilities and can therefore pay off short-term debts. A ratio of 4, for example, means that a business can pay off its current liabilities four times over. 

There are no hard and fast rules, though, on how a “good” current ratio is defined: it varies depending on industry. Some companies may operate perfectly well with a ratio under 1 – and a high ratio may not be a good thing: it may mean that a company isn’t using its assets as well as it potentially could. 

 

Why is current ratio important to investors?

Current ratio allows investors to start to understand a company’s short-term financial strength. It gives them an understanding of how cash-rich a business is, an idea of what its operating cycle looks like, and its working capital requirements and management. 

However, it shouldn’t be taken as a standalone measure of company health. Because inventory is included in current ratio calculations, a company with high levels of stock but poor sales may have a good current ratio, but may not have much chance of growth. 

Current ratio can also be easily manipulated if there are equal changes in both assets and liabilities. However, many investors will look at current ratio alongside other metrics to get an understanding of overall company health and performance before they decide whether to invest, and what to do with their current shares. 

 

“Stable Rise Limited is not authorised or registered by the Financial Conduct Authority. The marketing materials are not intended to provide financial advice nor promote any individual financial products.”

 

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