Could the current ratio be your next favorite fundamental?
Be smart and prepare before you risk your hard-earned money in the markets. That means understanding technical and fundamental analysis.
There’s a decent chance you’ve heard of the current ratio — and other liquidity ratios. And it’s likely you may have no idea what it means. People look at fundamentals and SEC filings and just blow them off cause they’re boring.
Yep, but they can be important.
As I often say, you have two accounts: your knowledge account and your money account. Focus on investing in and growing your knowledge account first. The smartest investment you can make is in yourself and your education.
So you may not use liquidity ratios much … but why turn down an opportunity to learn? You never know when information can give you an edge in trading.
Here, I’ll explain what a current ratio is and give you an overview of the liquidity ratio family. Plus I’ll cover how it can make you a smarter trader.
Table of Contents
- 1 What Is the Current Ratio?
- 2 What Are the Types of Ratios?
- 3 What Are the Components of the Current Ratio?
- 4 What Affects the Current Ratio?
- 5 Why You Should Use the Current Ratio
- 6 Calculating Current Ratio
- 7 How to Interpret Ratio Results
- 8 What Are the Limitations of the Current Ratio?
- 9 Frequently Asked Questions About the Current Ratio
- 10 Trading Challenge
- 11 Conclusion
What Is the Current Ratio?
In short, it’s a liquidity ratio. It shows a company’s ability to pay its short-term debt. Short-term obligations are generally classified as due within one year.
This tells investors how liquid a company could be in a bad situation.
Sound confusing? Don’t worry. Once I break it down, it should seem super simple. I often stress to my students to prepare before you risk your hard-earned money. Too many people are too lazy in this industry to put in the work to be successful.
What Are the Types of Ratios?
I’ve mentioned liquidity ratios a few times now. Again, look at the big picture. When you do that, you see that liquidity ratios are based on a borrower’s ability to pay off its short-term (or current) debt with its current assets.
Traders, investors, and analysts can look at these ratios to see what kind of position a company is currently in and how well it’s doing.
What’s liquidity mean in this context? It’s the ability to convert assets into cash quickly. There are multiple liquidity ratios. Each can tell you something slightly different about a company’s capacity to manage debt. At least, in the short term.
Let’s take a look at the different liquidity ratios.
Typically, this is the most common liquidity ratio used. Its simple to calculate, which makes it attractive to traders and investors.
Current ratio analysis can give you a quick view of a company’s liquidity using all the current assets and current liabilities. Where can you find that? It’s all in a company’s financial statements. I’ll break it down in a bit.
Quick Ratio or Acid Test
Feeling more conservative? The quick ratio — aka the acid test — is another common liquidity ratio. It’s a more conservative approach. Basically, the quick ratio takes out the least liquid current assets.
Investors tend to use this more for companies within certain industries. For instance, during the coronavirus pandemic, people may be concerned with a company’s ability to pay its short-term debt if it can’t sell its inventory as expected.
This is the least common of the group. But it’s good to understand how it works and what it could mean.
The operating ratio shows how efficiently a company’s management can generate money from its operating expenses. In other words, can the company live off its operations without resorting to using debt? The better the ratio, the lower the risk of financial issues. In theory, anyway.
It doesn’t include debt, which also makes me less interested in it.
What Are the Components of the Current Ratio?
Its components are pulled straight from the balance sheet. That’s where you can find a company’s assets, liabilities, and equity accounts listed.
Assets and liability have dedicated sections that are broken down into two groups — current and noncurrent. For the current ratio, we only have to worry about the current assets and liabilities. That makes things easier for us.
What’s an asset? An asset is simply something of value that a company owns. Current assets are the most liquid assets the company has. They can be sold, used, or consumed in some way.
Larger market cap companies tend to have a bigger list of current assets than the penny stocks I trade. Sometimes these tiny companies only have one or two current asset accounts.
I always teach my students to never believe in a penny stock. Most are scams or bound to fail. Some traders think they’ll find the next Microsoft. But 99% of these companies likely won’t even exist in a few years. Always be safe and protect yourself.
I think the best investment is in your education so you can grow your knowledge account. Matthew Monaco, one of my top students, helped me put together a 30-Day Bootcamp to help people understand the basics of trading penny stocks. In 30 days, you can better prepare before you risk your hard-earned money!
Liabilities are the opposite of assets. They’re something the company owes to another company or person. Current liabilities are similar in nature to current assets, except they’re what a company owes within the next year.
What Affects the Current Ratio?
Feeling better about it yet? Before we get to the formula, we have a little more foundation to lay…
Now that we know what makes up this ratio, we can understand why it could change.
Every company’s management has a risk tolerance. The more debt it takes on, the higher its financial risk. And the more current assets a company has, the lower its risk.
That doesn’t mean the ratio is right about risk tolerance. It only interprets the current position.
Why You Should Use the Current Ratio
Fundamentals are often overlooked, but they can tell you a lot about a company over time.
I sound like a broken record, but a company’s cash and liquidity levels can play a big role in a ticker’s movements.
So why would I look current ratios?
It’s true that in my trading, I rely on technicals more than fundamentals. But things also depend on which trading strategy I’m using. If I’m in and out of a trade fast, I usually don’t check fundamentals.
But sometimes I trade overnight plays that force me to be patient. When I plan to hold overnight, I tend to check more fundamentals. I may look at ratios and dig into SEC filings to figure out how bad the company needs cash.
Traders and investors can use the current and quick ratios to see a company’s trends and compare them to industry averages or standards. It’s one more check you can do before you commit to a trade.
Calculating Current Ratio
Check out how simple this is…
Current Ratio = Current Assets / Current Liabilities
It actually gets easier. Remember, you don’t have to calculate current assets or current liabilities either. It’s all on the balance sheet. All you have to do is the simple division.
And if you thought that was easy, try using the StocksToTrade software. This is an all-in-one trading platform that I helped create. I was sick of using so many websites to find the information I needed. StocksToTrade has everything you need in one place, even ratios.
How to Interpret Ratio Results
This is where you need to become a detective. Getting a number is great, but you must perform current ratio analysis. So what can you do with that information?
I already explained how you can use them for trading, but long-term investors read and interpret them slightly differently.
I mentioned trend analysis earlier. Companies release financial statements every quarter. Therefore, you CAN calculate and perform interpretations every quarter.
Comparing past ratios to the most recent allows you to see a trend. Is the number getting bigger or smaller?
If it’s growing, that can tell investors and traders that the company’s current assets are growing. Or its current liabilities are shrinking. Or it’s a combination of both.
I also mentioned an industry average. Every industry has different ratio averages based on factors that can tell you about a company’s overall health.
Again, these numbers don’t guarantee anything. They can only help you make more educated trading decisions.
What Is a Good Current Ratio? See a Real-Life Example
It depends on what you’re using it for. That’s why knowledge and interpretation are everything.
Regardless of why you’re looking at it, you want it to be at least 1.0. Or as close to it as possible in the worst-case scenario. If a company has a 1.0 ratio, that means it has enough value to cover its current debt.
Let’s look at an example. Advanced Micro Devices (NASDAQ: AMD) is a large-cap tech stock. Its current ratio is 2.1. That means it can cover its debt due within one year over two times with its liquid assets. Theoretically, this company has little financial distress for the current year.
What Are the Limitations of the Current Ratio?
It’s limited to only current debt and asset and short-term needs.
But just because a company doesn’t need money today doesn’t mean it won’t do a financing. It could have a ton of long-term debt maturing in the near future.
Frequently Asked Questions About the Current Ratio
What Is the Formula for the Current Ratio?
You can easily calculate the current ratio by dividing a company’s current assets by its current liabilities.
What Happens if the Current Ratio Is too High?
If a company's ratio is too high, that can mean it may be leaving too much money on hand. In this case, it may not be fully using its workable assets to continue to grow.
What Does a Current Ratio of 1.5 Mean?
A current ratio of 1.5 means the company can pay its short-term debt off one and a half times with the current assets it has available.
What Does a Current Ratio of 1.1 Mean?
A current ratio of 1.1 means a company can pay off its short-term debt a little over one time with its current assets.
What Causes a Current Ratio to Decrease?
This is where you can play detective. A company’s current ratio can decrease by either a decrease in current assets or an increase in current debts. You can research to look for potential reasons why.
One fundamental indicator probably won’t rock your trading world. But it’s one more piece to add to you your knowledge account. Be smart and focus on your education. Start in the markets with the right mindset.
You can learn how my students and I have become successful trading penny stocks in my Trading Challenge. But you have to apply. I only want to work with the most dedicated students. My Trading Challenge students get access to webinars, video lessons, my DVDs, my incredible chat room, and more.
I teach so traders like you can have the opportunity an make a better future. You ready to work for it? Apply today.
Bottom Line: Adding this fundamental to your collection can potentially help you make better tactical decisions in your trades. The more you know, the better.
You can never do enough research when preparing. But you can do too little. So many people make that mistake because they’re too lazy. They want easy answers or to get rich quick. Don’t be that trader.
Do you use current ratios in your trading plans and research? I love hearing from my readers. Leave a comment below!