More of this Feature • Part 1: Lesson 3 Main • Part 2: How to Get Statements • Part 3: What's a Balance Sheet • Part 4: Typical Balance Sheet • Part 5: Current Assets • Part 6: Receivables • Part 7: Receivable Turns • Part 8: Inventory • Part 9: Inventory Turns • Part 10: Inventory Example • Part 11: Prepaid Expenses • Part 12: Current Liabilities • Part 13: Working Capital • Part 14: WC Per Dollar of Sales • Part 15: Negative Work. Cap • Part 16: Current Ratio • Part 17: Quick Ratio • Part 18: Long Term Investment • Part 19: Property, Plant, Equip. • Part 20: Intangible Assets • Part 21: Goodwill • Part 22: Deferred Charges • Part 23: Debt, Debt to Equity • Part 24: Other Liabilities • Part 25: Minority Interest • Part 26: Shareholder Equity • Part 27: Book Value • Part 28: Com. & Pref. Shares • Part 29: Cap. Surplus, Reserve • Part 30: Treasury Stock • Part 31: Retained Earnings • Part 32: Formula & Calculations • Part 33: Putting it all Together • Part 34: Segment 2

Related Resources • Investing Lesson 1 • Investing Lesson 2 • Investing Lesson 3 • More Investing Lessons

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Current Ratio

The current ratio is another test of a company's financial strength.  It calculates how many dollars in assets are likely to be converted to cash within one year in order to pay debts that come due during the same year.  You can find the current ratio by dividing the total current assets by the total current liabilities.  For example, if a company has $10 million in current assets and $5 million in current liabilities, the current ratio would be 2 (10/5 = 2).

An acceptable current ratio varies by industry.  Generally speaking, the more liquid the current assets, the smaller the current ratio can be without cause for concern.  For most industrial companies, 1.5 is an acceptable current ratio.  As the number approaches or falls below 1 (which means the company has a negative working capital), you will need to take a close look at the business and make sure there are no liquidity issues.  Companies that have ratios around or below 1 should only be those which have inventories that can immediately be converted into cash.  If this is not the case and a company's number is low, you should be seriously concerned.

Inefficiency

If you're analyzing a balance sheet and find a company has a current ratio of 3 or 4, you may want to be concerned.  A number this high means that management has so much cash on hand, they may be doing a poor job of investing it.  This is one of the reasons it is important to read the annual report, 10k and 10q of a company.  Most of the time, the executives will discuss their plans in these reports.  If you notice a large pile of cash building up and the debt has not increased at the same rate (meaning the money is not borrowed), you may want to try to find out what is going on.

As I mentioned earlier, Microsoft current has the biggest cash hoard in the business world.  It's current ratio is in excess of 4.  The company has no long term debt on the balance sheet.  What are they planning on doing?  No one knows; the software giant may pay a dividend for the first time, pour the money back into research and development, or buy back shares.

Although not ideal, too much cash on hand is the kind of problem a smart investor prays for.

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