The current ratio: can the company pay its bills?

The lesson in plain words

The same lesson as the slides above, written out in full.

1. The Current Ratio

Welcome. The current ratio answers the most basic survival question in all of business. Can this company pay what it owes over the next twelve months? It matters because a company can look perfectly profitable on paper and still go bankrupt if it cannot pay its bills on time. That happens more often than you would think, especially during rapid growth, when cash gets tied up in inventory and money owed by customers. One note before we begin. This is financial education only, not financial advice.

• The current ratio answers the most basic survival question: can it pay its near-term bills?
• A company can be profitable on paper and still go bankrupt if it cannot pay on time.
• It is a quick read on short-term financial health.

A quick note: This is financial education only, not financial advice. Do not buy, sell, or hold anything based on this lesson.

2. Assets Over Liabilities

The formula is simple. It is current assets divided by current liabilities. Current assets are things that can become cash within a year, cash itself, short term investments, money owed by customers, and inventory. Current liabilities are what is due within the year, like payments to suppliers and short term debt. A current ratio of two point zero means the company has twice as much in short term assets as it owes in the near term, a comfortable position. A ratio below one means its near term obligations exceed its near term assets, which is a warning sign worth investigating.

• The ratio is current assets divided by current liabilities.
• Current assets are cash, receivables and inventory, anything convertible to cash within a year.
• A ratio of 2.0 means twice as much in short-term assets as obligations.
• Below 1.0, obligations exceed assets, a warning sign.

3. What the Number Means

Reading the number. Below one is a red flag, the company cannot cover its short term obligations from its short term assets, and is relying on future revenue, asset sales, or new borrowing. Not automatically fatal, some businesses run this way, but it needs watching. One to one and a half is tight but manageable, common in industries with fast, predictable cash cycles like grocers. One and a half to two and a half is healthy, a comfortable buffer, and the sweet spot for most industries. Above three is very liquid, and safe from a solvency view, but it raises a different question. Is management hoarding cash instead of investing it productively?

• Below 1.0: a red flag; it cannot cover its short-term bills from short-term assets.
• 1.0 to 1.5: tight but often manageable in fast cash-cycle industries.
• 1.5 to 2.5: healthy, a comfortable buffer, the sweet spot for most.
• Above 3.0: very liquid, but may point to cash hoarded instead of invested.

4. Not All Assets Are Equal

One important caveat before we finish. Not all current assets are equally liquid. Cash is immediately available. Receivables, the money customers owe, should arrive within thirty to ninety days. But inventory is different. If a retailer is sitting on five hundred million dollars of unsold stock, how quickly, and at what price, can that actually be turned into cash? Often slowly, and at a discount. So a current ratio that looks healthy but is built largely on stale inventory is weaker than the number suggests. Always look at what the assets actually are, not just the ratio.

• Not all current assets are equally liquid.
• Cash is available immediately; receivables arrive in 30 to 90 days.
• Inventory may sell slowly, and only at a discount.
• A ratio propped up by unsold inventory is weaker than it looks.