In a nutshell, current ratio is just current assets divided by current liabilities. This ratio helps to determine a company’s working capital, and as a rule of thumb, investors like to see a 2 to 1 ratio or higher.
When the current ratio falls below 2, it usually raises alarm bell but in some industries, it is possible to see a company with a low ratio of 1 but still be in strong financial shape.
Thus, current ratio must be seen comparatively, to prior periods and competitors in the same sector.
A current ratio is a good cursory guide but you are not privy to fundamental problems in a company. Excessive current assets may actually be harmful to a company.
Too much cash sitting idly means that the management is not utilizing it efficiently, especially when there are liabilities to pay down and result in lower interest expenses.
If account receivables are high based on sales volume, current assets will also be artificially inflated. Collection of outstanding accounts may be faulty. High inventory levels could imply change in consumer trends, decline in quality of sales team, or poor product lines.
The current ratio is only part of a larger fundamental analysis and should never be used as a sole test to ascertain a company’s financial strength. A good complement to the current ratio is the quick assets ratio, or known as the acid test.