Current Ratio you need to know: The liquidity indicator that reveals the true financial health of a company

Current Ratio is a figure that indicates whether a company can pay its short-term debts by comparing assets that can be converted into cash within a year with liabilities due in the same period. For investors and CFD traders, this number acts like a “heartbeat monitor” of the company’s financial health.

Why is the Current Ratio Important?

This ratio plays a key role for many groups:

• Business owners use it to assess how well the company maintains cash.
• Accountants track it because it relates to financial reporting.
• Lenders review this figure before deciding to extend credit.
• External investors use it to gauge risk before investing.

In the world of CFD trading, a deep understanding of the Current Ratio helps you select companies with stronger financial fundamentals.

Basic Components: Assets vs. Liabilities

Current Assets (

Current assets are resources that the company can convert into cash within a year. Not just normal items, but cash, cash equivalents, and quickly realizable assets.

Main types include:

• Cash and Cash Equivalents: Physical currency plus funds in checking accounts
• Marketable Securities: Stocks and bonds traded in the market
• Accounts Receivable: Money owed by customers
• Inventory: Stock of goods and raw materials
• Others: Prepaid expenses or other items within one year

) Current Liabilities ###

Current liabilities are obligations the company must pay within this year or the next; otherwise, they become overdue.

Main types include:

• Accounts Payable: Money owed to suppliers
• Short-term Debt Due Next Year: Loan repayments
• Unearned Revenue: Money collected from customers but goods not yet delivered
• Other Obligations: Taxes, fees, and other expenses

How to Calculate the Ratio and Real Examples

The formula for calculating the Current Ratio is straightforward:

Current Ratio = Current Assets ÷ Current Liabilities

( Example Calculation

Let’s look at Amazon’s figures for the fiscal year 2019:

• Current Assets: $96.3 billion
• Current Liabilities: $87.8 billion

Calculation: 96.3 ÷ 87.8 = 1.1

Meaning: Amazon has assets 1.1 times its liabilities, indicating the company has enough to cover short-term expenses.

) What is a Good Current Ratio?

Acceptable Range: Ratio of 1.0 or higher

• At 1.0, assets equal liabilities—similar to someone earning exactly enough to cover expenses, just breaking even.

Good Range: Between 1.5 and 2.0

• This indicates good liquidity, showing the company has a cushion to pay debts.

Caution Range: Significantly above 2.0

• Might mean the company holds excess cash or inventory, which can be inefficient, as funds could be invested to generate more profit.

Limitations of the Current Ratio to Know

Although useful, the Current Ratio has drawbacks that investors should be aware of:

1. Inventory Can Overstate Liquidity

Inventory is included in current assets, but converting it into cash can be slow, especially in industries with slow turnover or easily deteriorating goods. If most assets are inventory, a high ratio might be misleading.

2. Does Not Reflect Cash Flow

A company might have a high ratio but still face issues if liabilities are due soon and cash is tight. Cash flow is a separate concern that the ratio doesn’t reveal.

3. Does Not Show Asset Quality

Accounts receivable overdue by 6 months are counted the same as fresh cash. The ratio doesn’t differentiate asset quality.

4. Risk of Non-Payment

Companies relying on a few large customers may face high risk if those customers suddenly default. The ratio might look good but be misleading.

5. Ignores Off-Balance-Sheet Risks

Operating leases or contingent liabilities aren’t reflected in the ratio but can impact liquidity.

6. Industry Standards Vary

Banks and retailers have very different ideal ratios. A good number in one industry might be poor in another.

Common Misconceptions About High Current Ratios

Misconception 1: High = Good Liquidity

Truth: A high ratio doesn’t necessarily mean good liquidity. It depends on where the assets are. If most are inventory or receivables, liquidity might still be weak.

Misconception 2: High = Good Asset Management

Truth: Sometimes high ratios result from inefficient use of funds—money sitting idle, not invested or growing.

Misconception 3: The Higher, the Better

Truth: Extremely high ratios ###like 3.0 or above### may indicate underutilized resources, with excess cash that could be used for expansion or R&D.

( Misconception 4: High = Low Risk

Truth: A high ratio doesn’t eliminate risk. The company might have a few large customers or assets that are easy to sell.

) Misconception 5: High = Financial Stability

Truth: Financial stability involves many factors—net profit, cash flow, total debt, and trend over time—not just a high ratio.

How to Use the Current Ratio in CFD Trading

Assess Company Strength

Before opening a CFD position on a stock, check its Ratio. A ratio between 1.5 and 2.0 suggests a solid financial foundation and lower risk.

Compare with Overall Market Capacity

During economic downturns, companies with good ratios tend to fare better because they have a cushion. Weak companies ###with low ratios### may sink faster.

( Incorporate Technical Analysis

If a company’s ratio is strong and the price chart shows an upward trend, this combined signal can indicate a stronger buy opportunity.

) Monitor Earnings Reports

Observe changes in the ratio quarter over quarter. A significant decline can be a warning sign, while an increase or surpassing market targets may suggest rising stock prices.

Making the Ratio Work Effectively

Balance Liquidity and Growth

A good company maintains enough cash for safety but also invests in growth opportunities. The ratio shouldn’t be too low or too high; it’s about strategic balance.

Strategic Investment

Excess funds ###above a good ratio### should be used to expand the business, develop new products, or enter new markets to drive long-term growth.

( Financial Flexibility

An appropriate liquidity level )Current Ratio### helps the company manage unexpected expenses, seize opportunities, or survive economic downturns.

Summary

The Current Ratio is a useful indicator for understanding a company’s short-term liquidity, but it’s only one piece of the puzzle.

A good ratio (1.5 to 2.0) indicates a safe foundation, but remember, numbers alone don’t tell the full story. Consider asset quality, actual cash flow, and overall asset management.

For CFD traders, use the Current Ratio as an initial filter to select financially strong companies, then combine it with technical analysis, insights, and other qualitative factors to make smarter investment decisions.