15-5b Evaluating Trends

One of the most frequently used financial ratios is called the current ratio, which is calculated as current assets divided by current liabilities. The current ratio shows the firm’s ability to pay its current liabilities using current assets. The formula is as follows:

Current Ratio =

Current Assets Current Liabilities

Assume that the balance sheet of ABC Company shows current assets of $200 million and current liabilities of $50 million. The balance sheet of XYZ Company shows current assets of $300 million and current liabilities of $300 million. Which company is better situated to pay its current liabilities? XYZ Company has more current assets than ABC Company, but XYZ’s current ratio is only 1.00 ($300 million/$300 million). ABC Company has fewer current assets than XYZ Company, but ABC’s current ratio is 4.00 ($200 million/$50 million). ABC, therefore, has a stronger current ratio than XYZ. ABC is better situated to pay off its current liabilities.

A publicly traded company’s current ratio is tracked by financial analysts, investors, lenders, and company managers. Normally a higher current ratio indicates a better financial position, for it implies that a company has adequate liquidity to carry out business operations.

What is a good current ratio? To evaluate any financial ratio, a comparison should be made using one or more past years of a company’s data and benchmarking it against industry averages and similar ratios from key competitors. A rule of thumb is that companies should have a current ratio between 1 and 2.

The current ratio is often important in debt covenants. When a company borrows money, the lender will specify certain requirements to maintain the loan. These lending requirements, also called debt covenants, may indicate that the borrower must maintain a specified minimum current ratio, such as 2.5. This helps ensure that the borrower will have the money necessary to pay its interest obligations and later repay the loan.

Financial analysts, investors, lenders, and other parties analyze the financial statements to determine how well the company is performing and how well it is likely to do in the future. Positive trends in financial performance are indicators that the company has positive future prospects. This is good news for investors and typically leads to higher stock prices. Negative trends suggest a difficult future for the firm. In the worst case, the firm might even face financial ruin and bankruptcy.

Positive trends in financial performance are equally good news for lenders, as they indicate a high likelihood that loans will be repaid. For example, suppose Disney Corporation applies for a loan from Wells Fargo Bank. In deciding whether to loan the money, Wells Fargo may look at Disney’s financial statements to determine whether the company has a positive trend in net income. If net income has been steadily increasing during recent past years, this suggests that Disney will be profitable in the future and more likely to be able to pay back its loan.

Reality Che C k lO-5

If you had a half million dollars to invest, would you prefer to invest in a company that has made steadily increasing profits year after year? Or would you prefer instead to invest in a company that has experienced dramatic ups and downs in profitability, some years with huge profits and other years with huge losses? Explain the reasons for your preference.