BUSTING THE JARGON
At we are always looking to educate our readers about different ratios and methods of evaluating companies. In the McGregorBFA Weighted Composite Index, we talk about gearing and the current ratio. Here is what we mean: Gearing explains how a company finances its operations. This could be either through outside lenders, bank facilities or through shareholders agreements. The ideal company should be ungeared, but if it is geared, it should be geared effec- tively using the facilities that are available to it. This ratio is used to give interested parties an idea of the company’s ability to pay back its short-term liabilities, with its short-term or current assets including cash resources, inventory or debtors.
The higher the current ratio, the more capable the company is of meeting its obligations. A ratio under 1 suggests that the company would be unable to pay off its debts if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt.
The current ratio can give a sense of the efficiency of a company’s operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have a long inventory turnover can run into liquidity problems because they are unable to fulfil their obligations.
One should try and find companies in the same industry to compare current ratios. For instance, a manufacturing business will not be directly comparable to a retail business.