Question

current ratio and free cash flow ratio: explain its significance and how it is calculated.

Answer 1

currect ratio-

The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations. To gauge this ability, the current ratio considers the current total assets of a company (both liquid and illiquid) relative to that company’s current total liabilities. The formula for calculating a company’s current ratio is:

Current Ratio = Current Assets / Current Liabilities

The current ratio is called “current” because, unlike some other liquidity ratios, it incorporates all current assets and liabilities

The current ratio is also known as the working capital ratio.

Significance and interpretation

Current ratio is a useful test of the short-term-debt paying ability of any business. A ratio of 2:1 or higher is considered satisfactory for most of the companies but analyst should be very careful while interpreting it. Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio may not always be a green signal. It requires a deep analysis of the nature of individual current assets and current liabilities. A company with high current ratio may not always be able to pay its current liabilities as they become due if a large portion of its current assets consists of slow moving or obsolete inventories. On the other hand, a company with low current ratio may be able to pay its current obligations as they become due if a large portion of its current assets consists of highly liquid assets i.e., cash, bank balance, marketable securities and fast moving inventories. Consider the following example to understand how the composition and nature of individual current assets can differentiate the liquidity position of two companies having same current ratio figure.

free cash flow ratio-

The free cash flow/operating cash flow ratio measures the relationship between free cash flow and operating cash flow.
Free cash flow is most often defined as operating cash flow minus capital expenditures, which, in analytical terms, are considered to be an essential outflow of funds to maintain a company's competitiveness and efficiency.
The cash flow remaining after this deduction is considered "free" cash flow, which becomes available to a company to use for expansion, acquisitions, and/or financial stability to weather difficult market conditions. The higher the percentage of free cash flow embedded in a company's operating cash flow, the greater the financial strength of the company.

Formula

FCF/OCF Ratio = Free Cash Flows / Operating Cash Flows x 100%

significanceA more stringent, but realistic, alternative calculation of free cash flow would add the payment of cash dividends to the amount for capital expenditures to be deducted from operating cash flow. This added figure would provide a more conservative free cash flow number. Many analysts consider the outlay for a company's cash dividends just as critical as that for capital expenditures. While a company's board of directors can reduce and/or suspend paying a dividend, the investment community would, most likely, severely punish a company's stock price as a result of such an event.