The current ratio can be calculated as:
Current assets divided by Current liabilities
Significance of the current ratio
The current ratio measures the company’s ability to pay its short-term obligations and its debt obligations. Hence, a company with a larger current ratio is better than a company with a smaller current ratio. A company with a current ratio of less than 1 mat lack the liquidity to pay off its short-term obligations.
How option traders can make use of the current ratio
Option traders who rely on fundamental analysis can use the current ratio to determine company’s ability to pay off its short-term obligations. Inability to pay off the short-term obligations can send the company’s share price spiralling downwards.
Example
SunEdison Inc is a company that has a current ratio of less than 1 for its latest financial year, 2014. Compared to 2010, its current ratio was greater than 1.
(To highlight Total current assets)
(To highlight total current liabilities)
Apparently, SunEdison’s ability to pay off its short-term obligations has deteriorated over time. This has caused analysts to question its level of cash balances in the bank. In fact, SEC is investigating if the company has overstated its liquidity.
Incidentally, this has caused the company’s stock price to fall significantly from a high of approximately $30.