Nobody reads financial statements, we interpret them. So how do you interpret this statement?
“Current ratio is 1 point 8 4 to 1.”
1. As written, it would look like 1.84:1
2. It means there is 1.84 of whatever is in the numerator compared to what is in the denominator.
3. You have to know more.
A ratio in isolation is meaningless. Really!
What if you algebra is not your first language?
The numerator is what is on top, the denominator is what is on the bottom.
Here is an example:
Current Ratio = Current Assets (numerator: what is on top)
Current Liabilities (denominator: what is on the bottom)
If the current ratio is 1.84:1, this means there is $1.84 of current assets for every dollar of current liabilities. This is why I like to express ratios to two decimal points. If you are relatively new to financial statement analysis and it is expressed as 1.8:1, it is not as obvious that it is $1.80 of current assets for every $1 of current liabilities.
But we are not done yet!
Again, if you are newer to this, you may not have a gut feel (or even a clue) what current assets and current liabilities mean. If that is true, you need to restate this with the definitions.
First, let’s restate this. For every dollar of {current liabilities} the company had $1.84 of {current assets}.
Now replace the {terms in brackets} with {their definitions}.
Here you go:
For every dollar of {principal due in the next twelve months}, the company had $1.84 of {cash and thing they expect to turn into cash within the next twelve month}.
So what?
Well, I don’t know. And neither do you, yet. But if you know that the company had $1.30 in current assets for every dollar of current liabilities in the prior period, you know that liquidity is improving.
And if you know that a company of this type and size generally has a current ratio of 2.30:1, you know that the company is still less liquid than similar companies. Now you could ask more questions to understand why…and whether that is a concern.
You need to know
- What two items the ratio compares
- The definition of those two items.
- What the definition really means
- What the trend is in the company
- How the ratio compares to other similar companies
I know the pronunciation rules for Spanish and for Russian. I can pronounce a word in either of those languages. Doesn’t mean I know what it means.
If you can read a ratio out loud but you do not know everything in my ‘need to know’ list above, then you are not interpreting the financial statements. And if not, then you cannot make good decisions based on the ratios.
More at Lender’s Online Training
Learn how to analyze and interpret financial statements if you need to understand the business. I have just finished the eCourse on ‘Intermediate Financial Statement Analysis: Liquidity’ for my site www.LendersOnlineTraining.com. It covers how to read a ratio, the three most commonly used indicators of liquidity, where to get industry averages and whether they are a good fit.
This is one of the eCourses that requires a subscription so if you are not already signed up…do it now. Here is the rest of the eCourse list.
Intermediate Financial Statement Analysis: Intro is complimentary and so are several other eCourses. Decide if it is time to go back to school, up your game and learn how to go beyond ‘reading’ to ‘understanding’.
