- We're now going to hone in
on the leverage component of return on equity.
- Now, there are a host of different types
of leverages ratios all getting in a measure
of how certain classes of assets are being financed.
So first we'll look at the current ratio,
which is one of the type five ratios of all time.
Then we'll look at a bunch of other leverage ratios.
- In addition to being a measure
of a company's short-term leverage,
the current ratio is also a measure of liquidity.
Liquidity refelcts the ability of a company
to pay its obligations in the short term.
Short term we typically define as less than one year.
- [Insutructor] Now, the current ratio's computed
as current assets divided by current liabilities.
Let's remind you what a current asset is
and what a current liability is.
A current asset is an asset expected to be used
or turned into cash within one year.
- [Instructor] Examples of common current assets include
cash, accounts receivable, and inventory.
- [Instructor] Now, similarly, current liabilities
are the liabilities that we expect
to have to pay within one year.
Accounts payable is a good example of a current liability.
We're going to pay our suppliers that we owe within a year.
- So the current ratio reflects the balance
between the assets that we're going to have
or are going to become cash within one year,
and the liabilities that we will have
to pay within one year.
And we typically like to see a bit of a cushion here.
- So the current ratio for Nike is 2.5 in 2018.
For Under Armor, it's almost exactly two.
The general rule of thumb for current ratios
is that they're typcially greater than two.
- Banks like to see from borrowers current ratios
typically greater than two.
In fact, it's very common in bank loan contracts
that a bank will say to a borrower,
"Your current ratio has to stay above a certain level,
"above 1.5 or above two."
- If you fall below that specified level,
creditors can start to get nervous.
Maybe you're not going to be able to pay us
when you're supposed to pay us,
and so your loan is in default.
So the rule of thumb is current ratios
should be greater than two.
- Yeah, but that's an old rule of thumb.
In the new world that we have now,
the technology world, companies are able
to manage their current assets much more efficiently.
- Companies don't need as much inventory
as they used to need because their information systems
can track their inventory very carefully.
So companies don't need to have
as much extra inventory lying around.
- For example, Walmart, with all its groceries
with its limited shelf life,
has a current ratio that's down to 0.8.
Target's current ratio, 0.83.
- Now you will notice that companies in similar industries
tend to have similar current ratios, and that makes sense.
If we're doing the same things,
we should kind of look the same
from a financial point of view.
- So the old rule of thumb,
the rule that your mom and dad
learned when they went to school,
was current ratio should be about two.
- Well, current ratios are often less than two now,
but in general, remember that the current ratio
reflects liquidity, the ability of a company
to pay its debt in the short term.
And we like to see that steady.
- And if that starts to slip in any given company,
we get nervous about that company's ability
to pay its debts in the short term.