One of the most commonly used debt-measurement tools in financial reporting is the current ratio, which measures the assets a company plans to use over the next 12 months with the debts it must pay during that same period. This ratio lets you know whether the company will be able to pay any bills due over the next 12 months with assets it has on hand.
You find the current ratio by using two key numbers:
Current assets: Cash or other assets (such as accounts receivable, inventory, and marketable securities) the company will likely convert to cash during the next 12-month period
Current liabilities: Debts the company must pay in the next 12-month period, including accounts payable, short-term notes, accrued taxes, and other payments
How to calculate the current ratio
The formula for calculating the current ratio follows:
Current assets ÷ Current liabilities = Current ratio
Using information from the balance sheets for Mattel and Hasbro, here are their current ratios for the year ending December 2007:
Mattel
$3,556,805,000 (Current assets) ÷$1,716,012,000 (Current liabilities) = 2.07 (Current ratio)
So Mattel has $2.07 of current assets for every $1 of current liabilities.
Hasbro
$2,508,702,000 (Current assets) ÷$960,435,000,000 (Current liabilities) = 2.13 (Current ratio)
So Hasbro has $2.61 of current assets for every $1 of current liabilities.
What do the numbers mean?
The key question to ask is whether a company's current ratio shows that it's able to cover short-term obligations. Generally, the rule of thumb is that any current ratio between 1.2 and 2.0 is sufficient for a business to operate. Keep in mind that the ratio varies among industries.
A current ratio below 1 is a strong danger sign that the company is headed for trouble. A ratio below 1 means the company is operating with negative working capital; in other words, its current debt obligations exceed the amount of money it has available to pay those debts.
A company also can have a current ratio that's too high. Any ratio over 2 means the firm isn't investing its assets well. The company can probably put some of those short-term assets to better use by investing them in growth opportunities.
However, many lenders and analysts believe that the current ratio isn't a good enough test of a company's debt-paying ability because it includes some assets that aren't easy to turn into cash, such as inventory.
A company must sell the inventory and collect the money before it has cash to work with, and doing so can take a lot more time than using cash that's already on hand, or just collecting money due for accounts receivable, which represent customer accounts for items already purchased.
