In the emergency room the first question is: Can this patient survive? Similarly, the first issue in analyzing financial statements is: Can this company survive?
Business survival means being able to pay the bills, meet the payroll, and come up with the rent. In other words, is there enough liquidity to provide the cash needed to pay current financial commitments? “Yes” means survival. “No” means bankruptcy.
The urgency of this question is why current assets (which are expected to turn into cash within a year) and current liabilities (which are expected to be paid in cash within a year) are shown separately on the balance sheet. Net current assets (current assets less current liabilities) is known as working capital.
Because most businesses cannot operate without positive working capital, the question of whether current assets exceed current liabilities is crucial.
When current assets are greater than current liabilities, there is sufficient liquidity to enable the enterprise to survive. However, when current liabilities exceed current assets the enterprise may well be in immanent danger of bankruptcy.
The financial ratio used to measure this risk is current assets divided by current liabilities, and is known as the current ratio. It is expressed as “2.5 to 1” or “2.5 1” or just “2.5.” Keeping the current ratio from dropping below 1 is the bare minimum to indicate survival, but it lacks any margin of safety.
A company must maintain a reasonable margin of safety, or cushion, because the current ratio, like all financial ratios, is only a rough approximation. For this reason, in most cases a current ratio of 2 or more just begins to provide credible evidence of liquidity.
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