How to make money in stocks. Lesson 30. Current ratio. Alibaba
The current ratio shows whether a company can pay off its short-term debts that are payable during the year. You can measure the ratio by dividing total current assets by total current liabilities.
The current ratio helps investors and analysts find out whether a company can make the most of its current assets on the balance sheet to pay off current debts and other payables.
Managers, investors, and creditors use the current ratio to analyze financial positions, make corrections and assess whether companies can pay off their debts on time.
Fundamentally, a company’s liquidity is closely connected with its ability to meet obligations to creditors or suppliers. If a company has fewer funds than it needs, there’s a high probability of default. If it has more funds than necessary, their cost will make profits shrink. If we’re talking about liquidity, a balanced position is preferable.
As business operations are different for each sector, it makes sense to always compare companies within the same industry.
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The calculation is pretty straightforward. What we do is basically divide current assets by current liabilities. This figure is typically readily accessible. However, if you still wish to calculate it on your own based on financial statements, here’s a formula you should look into.
Current Ratio = Current Assets / Current Liabilities
Current assets—on the balance sheet—include all those items that are either cash or can be converted into cash in less than a year. Current liabilities—on the balance sheet—are those liabilities that are due for payment during the year. They include payrolls, accounts payable, taxes, short-term loans, and current long-term debts.
Increasing the numerator (current assets) increases the ratio and vice versa.
Increasing the denominator (current liabilities) decreases the ratio and vice versa.
Real-world case. #BABA
1. Let’s calculate the ratio for the quarter ended in December 2020:
Current Ratio = Current Assets / Current Liabilities = $91,606 / $54,890 = 1.67
2. Let’s calculate the ratio for the quarter ended in March 2021:
Current Ratio = Current Assets / Current Liabilities = $98,196 / $57,596 = 1.70
Alibaba Group Holding’s current liquidity ratio is 1.70. #BABA’s current assets are equal to $1.70 for every dollar of current debt. This proves that the company has decent short-term financial stability.
Alibaba Group has more than enough assets to meet current obligations if, let’s say, it has to immediately pay off its debts and covert its current assets into cash.
3. Over the past 5 years, #BABA’s current ratio hasn’t dropped below 1, stably ranging from 1.30 to 1.90).
4. BABA’s current ratio is higher than that of 57% of other companies in the e-commerce industry. The industry average is 1.50.
When it comes to e-commerce companies, the ratio is typically within reasonable limits, as they have adequate reserve funds.
In broad terms, the current ratio of companies with cash sales, quick stock turnovers, and strong positions regarding suppliers may be less than 1. These companies normally don’t have liquidity problems, unless they stop operating or start cutting back.
The current ratio that’s equal to the industry average or slightly higher is generally seen as acceptable.
If the current ratio is below the industry average, it directly shows the risk of insolvency.
The higher the current ratio, the better a company can meet its obligations. If the current ratio is excessively high compared to peers, most likely, the management team doesn’t control assets efficiently, which may affect profits.
Accelitable ratios vary by industry, while stable companies usually show metrics between 1 and 3.
The current ratio below 1 means that a company won’t be able to pay off its debts at the moment. This means that its financial position is unstable, but it doesn’t state that it’ll necessarily go bankrupt because there are many options to find financing sources. Nevertheless, an indicator like that is definitely an alarming sign.
All other things being equal, a lender who expects repayment within the next 12 months will consider a high current ratio to be better than a low one. This is because a high current ratio means that a company is more likely to meet its obligations that are due within the next 12 months.
Subtle aspects of the use
A truly efficient analysis can only be done within the industry itself and in dynamic terms.
It also makes sense to analyze the structure of the assets and obligations. For instance, the current assets include those that cannot be easily liquidated.
Let’s sum things up
1. Prudential liquidity management is a way to increase profitability thereby making investors richer. A profitable deal with lenders regarding the loan terms and conditions can improve the overall liquidity position and reduce the cost of working capital financing.
2. Companies having a hard time getting receivables paid or having long stock turnovers may face liquidity problems, as they can’t ease their obligations.
3. The current ratio gives an idea of how efficient an operating cycle is. Higher current ratios may speak of an opportunity to invest in undervalued stocks during the financial crisis.