What do you look at before investing your hard-earned money in a stock? I bet you focus on return on equity (ROE). After all, shouldn’t investors only be concerned with how much money they earn? Why bother with anything else.
This is one of the reasons retail investors invest in poor quality stocks.
Do you know that for Warren Buffett ROE is secondary? He instead looks for stocks with low debt to equity and high current ratio. The idea is simple… You should not make long-term investments in a company that cannot pay its short-term liabilities?
This is where the current ratio comes into the picture. It tells you whether a company has enough liquid assets to pay its short-term debt.
Warren Buffett does not invest in companies with a current ratio less than 1.50.
However, the ideal current ratio varies across industries. For example:
- The current ratio of Tata Consultancy Services Ltd (TCS) is 2.13.
- The current ratio of Shriram Transport Finance Company Ltd (SRTRANSFIN) . is 10.9.
Does this mean that Shriram Transport Finance Company is better than TCS?
Current ratio does not tell you which company is more profitable. That is the job of ROE.
Hindustan Petroleum Corporation Ltd (HPCL) generated a ROE of 30.88% in 2020-21. Its current ratio is 0.71. Whereas ROE of Reliance Industries was 7.97% in 2020-21. Its current ratio is 1.16.
HPCL generated higher returns for investors. But Reliance Industries is financially stronger in the short-term.
A company can have higher ROE, but if it cannot pay its short-term debt then there is a high risk of default. In such cases, even a ROE of 100% is useless. This is why the current ratio is important.
Current ratio is a type of liquidity ratio. It tells you whether or not a company can repay its short-term obligations or loans. A company can work in the long-term only if it has solid short-term financials.
In this article:
- What is the current ratio?
- How to calculate current ratio?
- What is the ideal current ratio?
- Current ratio analysis & interpretation
- Limitations of current ratio
- FAQs on current ratios
Watch What are Liquidity Ratios
What is Current Ratio?
Current ratio measures the ability of a company to repay its short-term debt. This is debt due within one year and must be repaid using current assets only. Ideally, a company must have enough assets to repay its debt without raising fresh capital and diluting its shareholding.
Current ratio compares a company’s current assets and current liabilities. It is also known as working capital ratio.
Current assets are those which can be converted into cash within one year. It includes:
· Mutual fund investments
· Money market instruments like treasury bills, commercial papers etc.
· Inventory (raw materials, work in progress and finished goods)
· Accounts receivables (from vendors or customers)
· Prepaid expenses (advance payments to suppliers)
Current Liabilities are debt or loans payable within one year. It includes:
· Accounts payable (to suppliers)
· Outstanding expenses (salary, wages, electricity bills, rent etc).
· Advance received from customers
· Deferred taxes
· Declared but not yet paid dividends
How to Calculate Current Ratios?
To calculate the current ratio, divide a company’s current assets with its current liabilities. This data is available in the company’s balance sheet.
[Read More: How to Analyse Balance Sheet of a Company]
Let us calculate the current ratio of Tata Consultancy Services Ltd for the year ending 31st March 2021.
|Current Assets||(Rs in Crores)|
|Trade Receivables||₹ 30,079|
|Unbilled Receivables||₹ 6,583|
|Cash and cash equivalents||₹ 6,858|
|Bank Balances||₹ 2,471|
|Miscellaneous financial assets||₹ 1,394|
|Other assets||₹ 11,255|
|Total Current Assets||₹ 99,280|
|Current Liabilities||(Rs in Crores)|
|Lease liabilities||₹ 1,292|
|Trade payables||₹ 7,860|
|Other financial liabilities||₹ 6,150|
|Unearned and deferred revenue||₹ 3,650|
|Other liabilities||₹ 4,068|
|Employee benefit obligations||₹ 3,498|
|Income tax liabilities (net)||₹ 6,243|
|Total Current Liabilities||₹ 34,155|
Current Ratio Formula = Current Assets / Current Liabilities
= Rs 99,280 / Rs 34,155
The current ratio of TCS is 2.90. This means that TCS can cover its liabilities 2.90 times. You can also say that TCS has 2.90 times more assets than liabilities. The higher the current ratio, the stronger a company’s short-term financial position is.
However, there is no fixed acceptable current ratio. It differs industry-wise. Seasonal and capital-intensive sectors have low current ratios. The current ratio of Bajaj FinServ Ltd is only 0.10. This is because Bajaj FinServ Ltd is a lending company and might keep low cash reserves.
However, the ideal current ratio lies between one and three.
What is the Ideal Current Ratio?
· Current Ratio > 1 is a good sign.
It means the company’s current assets are greater than current liabilities. Such companies have solid cash flows and have minimum credit risk.
· Current Ratio < 1 is a potential red flag for investors.
This happens if a company’s current assets are less than its current liabilities. Such companies may have to raise additional funds or sell long-term assets to pay their loans. They carry high credit risk.
· Current Ratio = 1
This happens when a company’s assets and liabilities are equal. It means a company has just enough assets to repay its loans. But even a small decrease in cash flow can lead to credit defaults.
Hence it is recommended to invest in companies with a current ratio more than one. Generally, a high current ratio is ideal. But a current ratio of more than three can be bad for investors.
An exceptionally high current ratio means that the company is hoarding cash. This is not a productive use of investor’s money.
Hence, the ideal current ratio lies between one and three.
How to Use Current Ratio in Stock Analysis
There are two ways in which current ratio can be used in stock analysis:
· Analysis of historical current ratio trend.
· Current ratio Vs industry ratio analysis.
Current Ratio Trend Analysis
What is the goal of long-term investing? To invest in consistently sound companies. You don’t want to invest in one-hit wonders.
Similarly, a company might have a good current ratio in a particular year. But this is not enough. You need to study its five-year trend. Is the trend upwards or downwards? Is the company getting financially stronger or weaker?
There is a consistent increase in the current ratio of Dabur India Ltd and Marico Ltd. This means these companies are getting financially stronger.
Now notice the current ratio trend of Godrej Consumer Products Ltd. It shows a downward trend. The company’s short-term financial liquidity is getting worse.
A downward trend in current ratio can be an early sign of financial distress in a company.
Current Ratio Vs Industry Current Ratio
Current ratio varies across sectors. The below graph shows the average current ratios of 2/3 wheelers, banks, refineries and the personal products sector.
- The average current ratio for the 2/3 wheeler sector is 1.70.
- Whereas its 1.26 for the refineries sector.
- The average current ratio of top 10 banks in India is 4.25.
As you can see, banks maintain higher liquidity than other sectors. Here the ideal current ratio rule is not applicable.
The below chart shows the current ratio of banking sector stocks.
While current ratio is great at analysing a company’s short-term position, it does have certain limitations.
3 Major Limitations of Current Ratios
1. Current Ratio Includes Inventory:
To calculate current ratio, inventory is added to current assets. It can be in the form of raw materials, work in progress and finished goods.
But converting inventory into cash is not easy. It can take more than a year. The process is longer for goods in the raw material or work in progress stage.
There can also be a big gap between sales and actual receipt of cash. This happens in the textile sector. Hence, the current ratio does not work in companies with huge inventory.
Current assets include prepaid expenses, advance received etc. which is not real cash.
The below table shows the current ratio of top four personal products companies in India.
|Personal Products Companies||Current Ratio|
|Hindustan Unilever Ltd||1.04|
|Godrej Consumer Products Ltd||1.08|
From a cursory look, you might say that Marico Ltd is best prepared for handling its short-term debt. While HUL has the lowest current ratio and is least prepared.
But you would be wrong…
In reality HUL has the best current ratio not Marico Ltd or Emami Ltd.
Below is the break-up of the current assets of these four companies.
Look at the amount of inventory each company holds. HUL has the lowest inventory. Majority of its assets are in the form of cash and bank balance. Whereas Godrej Consumer Products Ltd has 35.42% in inventory and 24.07% in trade receivables.
Now imagine if the company is unable to recover its money from debtors. It cannot even sell its inventory due to lower demand (as seen during the pandemic).
In such cases, how will the company pay its debt?
This is why you also need to check a company’s quick ratio and cash ratio. Quick ratio excludes inventory while calculating current ratio. Whereas cash ratio only includes cash and cash equivalents as assets.
2. Current Ratio does not work for Seasonal Companies:
These stocks are in demand for a specific period of time. For example: The sale of air conditioners, coolers is very low during winters. Cement and paint sales drop during the monsoon season. Bata enjoys high sales during monsoons due to their rainy shoes. All this has a direct impact on a company’s cash flow and current ratio. Hence, it is recommended to check yearly trends in current ratios instead of standalone numbers.
3. Current Ratio Excludes Frequency of Sales or Obsolete Produce:
Companies selling non-durable goods have to write-off inventories due to poor frequency of sales or obsolete products. This includes food, clothing, shoes etc. Current ratio of a company selling highly non-durables has wide fluctuations.
4. Current Ratio Analysis does not work in Inter-Industry Comparison:
Current ratio differs widely among industries. So, you cannot compare the current ratio of TCS with Avenue Supermarts Ltd. The below table shows the average current ratio of top ten companies in India.
|Company Name||Market Capitalisation||Current Ratio||Sector|
|Reliance Industries Ltd||14,34,067||1.16||Integrated Oil & Gas|
|Tata Consultancy Services Ltd||12,19,577||2.13||IT Consulting & Software|
|HDFC Bank Ltd||8,16,588||1.96||Banks|
|Hindustan Unilever Ltd||5,82,874||1.04||Personal Products|
|HDFC Ltd||4,49,177||1.02||Housing Finance|
|Bharti Airtel Ltd||2,95,965||0.49||Telecom Services|
|Asian Paints Ltd||2,92,522||1.62||Furniture-Furnishing-Paints|
|Avenue Supermarts Ltd||2,14,899||3.67||Department Stores|
|Maruti Suzuki India Ltd||2,10,208||1.15||Cars & Utility Vehicles|
FAQs on Current Ratio
1. What is current ratio?
Current ratio is a liquidity or efficiency ratio that measures a company’s ability to pay short-term loans arising within a year. It shows the near-term financial health of a company.
2. What does a current ratio of 1.5 mean?
A current ratio of 1.5 means a company has 1.5 times current assets than its loans. Warren Buffett does not invest in companies with a current ratio lower than 1.50.
3. What is a good current ratio?
As a rule of thumb, the ideal or good current ratio lies between one and three. A ratio below one might indicate poor cash flow or inability to look after its short-term loans. A current ratio of more than three can reflect under-utilisation of assets.
4. How is current ratio calculated?
To calculate current ratio, you need two things –
Current assets are assets which are readily available (cash, bank balance) or can be converted into cash within 12 months. Current liabilities are loans payable within 12 months.
Current assets are cash, inventory, bills receivable, prepaid expenses etc. Current liabilities are bills payable, outstanding rent, bills, salaries or loan instalments.
To calculate current ratio, you need to divide current assets by current liabilities.
5. What is the difference between current ratio and quick ratio?
Unlike the current ratio, the quick ratio does not include inventories. It is calculated as: (current assets – inventory) / current liabilities.
6. Which is better – current, quick or cash ratio?
Quick ratio is a much better indicator of a company’s liquidity position than current ratio. Cash ratio is suitable for conservative investors. Read everything on liquidity ratios.
7. What is the difference between current ratio and debt to equity ratio?
Current ratio tells you whether a company has enough liquid assets to pay its short-term debt. Whereas debt to equity ratio compares the total debt a company has against its equity capital.
8. Is current ratio and interest coverage ratio the same?No, Interest coverage ratio tells you whether a company can pay interest on loans or borrowings. While the current ratio deals with principal repayment.
Current ratio is just one of the gazillion ratios that you must analyse before investing your hard-earned money in a stock. Sounds daunting? Where will you get so much time and resources to analyse more than 4,000 stocks listed in the market? Relax, we at Samco Securities have come up with a quick and FREE solution – Samco Stock Rating. Simply open a FREE Samco Demat account and get instant rating of all stocks listed in India.