Fundamental Knowledge for Successful Investment: What is the Current Ratio?

The 'current ratio' is one of the important indicators when looking at financial statements, and it is a concept that you must know.

What is the Current Ratio?

Current Ratio (Quick ratio)is one of the indicators that evaluates a company's short-term debt repayment capacity, and itmeans 'the ratio of quick assets to current liabilities'In this case,quick assets refer to assets that can be immediately converted into cash, such as cash and cash equivalents, accounts receivable, and short-term financial products, while current liabilities refer to liabilities that must be repaid within one year.

Simply put, the current ratio is an indicator that shows how quickly a company can repay its short-term debt using cash-like assets and accounts receivable. Generally, a current ratio of 100% or more is considered stable, and if it is 70% or less, it is considered likely that the company will have difficulty repaying its short-term debt.

Therefore, for successful investment, it is important to analyze the company's financial statements, including the current ratio, to understand its short-term debt repayment capacity and stability. In addition, the current ratio provides useful information for establishing a company's fund procurement and operation plan.

Importance of the Current Ratio: Why Should You Know It?

The reason why investors need to know the current ratio is that it is a very important indicator forjudging a company's short-term payment capacity and creditworthiness.

For example, the lower a company's current ratio, the more likely it is to face difficulties in repaying short-term debt, which can lead to a decline in the company's creditworthiness and an increase in the cost of fund procurement. Conversely, a higher current ratio indicates that the company has a strong short-term debt repayment capacity, which increases investor confidence and stability in the company.

Especially in stock investment, the financial condition of a company has a major impact on stock prices, so it is good to actively utilize financial indicators, including the current ratio, when making investment decisions. By doing so, you can minimize investment risk and maximize returns.

How to Calculate the Current Ratio

The current ratio is calculated using the following formula.

• Current Ratio = (Quick Assets / Current Liabilities) x 100

Here,'Quick Assets'refers to assets that can be immediately converted into cash, such as cash and cash equivalents, short-term financial products, and accounts receivable, and 'Current Liabilities'refers to liabilities that must be repaid within one year.

At this time, you can also calculate the modified current ratio by multiplying the total assets in both the denominator and numerator. This is used for relative comparison because the composition of quick assets and current liabilities varies depending on the industry.

The calculated current ratio is generally considered favorable if it is 100% or more, and unfavorable if it is 70% or less. However, this is not an absolute standard, and it can be applied differently depending on the industry and characteristics of the company.

Current Ratio and Corporate Financial Health

The current ratio is one of the indicators that evaluates a company's short-term debt repayment capacity, and a higher ratio indicates that the company's financial health is better. The reason for this is as follows.

• Since quick assets are assets that a company can convert into cash in the short term, a high current ratio means that the company is less likely to face difficulties in repaying short-term debt.
• Quick assets are one of the indicators that represent a company's liquidity. In other words, a company with a high current ratio has abundant liquidity, so it can be seen that it has a strong ability to cope with economic uncertainty.
• Quick assets also play an important role in enhancing a company's creditworthiness. Since financial institutions consider a company's financial indicators, including the current ratio, when reviewing loan applications, companies with a high current ratio can obtain favorable conditions such as interest rates and loan limits.

Limitations and Precautions of the Current Ratio

The current ratio is a useful indicator for evaluating a company's short-term debt repayment capacity, but it has some limitations and precautions.

• Since quick assets do not include inventory or prepaid expenses, a high current ratio does not necessarily mean that the company's actual liquidity is high. This is because these assets take time to convert into cash or their value can fluctuate.
• The appropriate level of the current ratio can vary depending on the industry. For example, in the manufacturing industry, where the proportion of raw material purchases is high, even if the current ratio is relatively low, it can be considered that the debt repayment capacity is sufficient, but in the distribution industry, a high current ratio is necessary for stable management.
• The current ratio can be distorted depending on the method of evaluating quick assets and current liabilities. For example, inflating quick assets or reducing current liabilities can make the current ratio appear higher than it actually is, so caution is required.

Comparison with Other Financial Ratios: Relative Importance of the Current Ratio

The current ratio is useful for evaluating a company's short-term debt repayment capacity, but it should be considered in conjunction with other financial ratios.

For example, the debt-to-equity ratio is useful for evaluating a company's long-term debt repayment capacity, and the times interest earned ratio is useful for evaluating a company's ability to pay interest expenses. The accounts receivable turnover ratio is useful for understanding the collection period of accounts receivable, which is one of the most important items among quick assets.

Therefore, for successful investment, it is important to comprehensively evaluate a company's financial condition and business performance by considering various financial ratios such as the current ratio.

Conclusion

As it is one of the indicators that determines the stability of a company, I hope you will remember it and use it effectively.