Why is the Current Ratio an important tool, but one that must be used with caution?

What is the Current Ratio

Liquidity Ratio (Current Ratio) is a measure used to assess a company’s ability to meet short-term liabilities by comparing total working capital to debts due within one year.

This indicator is important for investors, business owners, lenders, and financial analysts because it helps understand whether the company can convert assets into cash to pay off debts and whether its working capital is sufficient.

Main Components of the Current Ratio

This metric consists of two main components:

Current Assets (

Current assets are resources that can be converted into cash within the next year. The main types include:

• Cash and cash equivalents such as bills, coins, and savings account balances
• Marketable securities like stocks and bonds
• Trade receivables money owed by customers to the company
• Inventories finished goods and raw materials for production
• Other current assets such as prepaid expenses

) Current Liabilities ###

Current liabilities refer to amounts the company must repay within the next year. The main types include:

• Accounts payable money owed to suppliers
• Short-term debt loans due within the year
• Unearned revenue money received from customers before delivering goods
• Accrued expenses expenses that have been incurred but not yet paid

Common Misconception: A High Ratio Does Not Always Mean Good Financial Health

Many investors think that a high Current Ratio = a well-liquidated company, but this is a major misconception.

( Reasons why a high ratio might be a warning sign

1. It does not reflect asset quality
This ratio considers all assets equal, but in reality, inventories of 1 million baht and cash of 1 million baht carry different risks. Inventories may spoil or be unsellable, and receivables may be uncollectible.

2. Indicates inefficient asset management
A company with excessive cash or inventories may not be investing in growth opportunities, R&D, or new branches. This reflects inefficient resource utilization.

3. Ignores cash flow
A company might have a high ratio but still face liquidity issues if debts are due before assets can be converted into cash.

4. Cross-industry differences
Different industries have different standards. A ratio of 1.5 might be good in one industry but very low in another.

Before trusting a high ratio, ask yourself:

• What are the main current assets? Cash is best, inventories are the riskiest
• Is the company profitable? Ability to pay debts should be paired with revenue-generating capacity
• How is resource utilization? Good companies use excess funds for expansion, R&D, or entering new markets

How to calculate the Current Ratio

The formula is simple:

Current Ratio = Current Assets ÷ Current Liabilities

) Example calculation from real data

From Amazon’s balance sheet in fiscal year 2019:

• Current assets: $96.3 billion
• Current liabilities: $87.8 billion

Current Ratio = 96.3 ÷ 87.8 = 1.1

This result indicates Amazon has 1.1 times more current assets than current liabilities, meaning it can cover short-term debts.

What is a good ratio?

1.5 to 2.0 is considered a safe zone, indicating the company has enough cash and not too much idle funds.

Minimum 1.0 means assets equal liabilities, but this can be risky because small problems could cause liquidity issues.

Above 2.0 suggests the company might not be using its capital efficiently; excess idle funds may not generate returns.

Limitations of the Current Ratio

1. Inventories may not convert quickly into cash
In industries with slow turnover or perishable goods, inventories may not be reliable assets.

2. Does not consider uncollected receivables
Some receivables may be uncollectible, making the ratio appear higher than it truly is.

3. Excludes off-balance sheet obligations
Operating leases, contingent liabilities, or guarantees may not appear on the balance sheet but affect debt repayment ability.

4. Does not indicate profitability
A high ratio does not mean the company is profitable; it could still be loss-making or have minimal cash flow.

How to use the Current Ratio in CFD trading

For traders interested in long positions on company stocks via CFDs:

1. Assess financial health

A current ratio between 1.5 and 2 indicates low short-term liquidity risk, making it a safer choice for buy positions.

2. Combine with technical analysis

If the company has a strong current ratio and technical indicators show an uptrend, it could be a strong buy signal.

3. Monitor earnings reports

A significant decrease in the current ratio from the previous quarter may be a warning sign, suggesting to consider closing buy positions or avoiding new ones.

4. Compare with industry peers

A company’s ratio should be compared to industry peers. A better current ratio than competitors may indicate a stronger market position.

Summary

The Current Ratio is a useful tool but should not be used alone. Key points to understand are:

• A high ratio ≠ always a good company
• Asset quality matters more than quantity
• It should be considered alongside other indicators like Quick Ratio, net profit, and cash flow
• Different industries have different standards

For investors, entrepreneurs, and CFD traders, a comprehensive analysis including Current Ratio along with qualitative factors and other data will help make smarter investment decisions and reduce risks.