One of the biggest challenges to business owners is managing their cash flow. In other words, will I have enough cash to pay my vendors when the time comes? And if not, can I liquidate some things to help cover the difference? The current ratio helps business owners answer exactly these questions—hopefully before they find themselves in a cash flow pinch.
The current ratio, also known as the working capital ratio, is a measure of a company’s liquidity, or its ability to meet short-term obligations. By comparing current assets to current liabilities, the ratio shows the likelihood that a business will be able to pay rent or make payroll, for example.
To calculate your own current ratio, use our free calculator tool. Grab your most recent balance sheet and input the values for current assets and current liabilities. Read on to learn how to analyze (and perhaps improve) your results
The Formula for Calculating Current Ratio
The current ratio is often referred to as the working capital ratio, so let’s start with a quick refresher on what working capital means.
Working capital generally refers to the money a company has on hand for everyday operations and is calculated by subtracting current liabilities from current assets.
The working capital ratio, on the other hand, shows a company’s current assets and current liabilities as a proportion, rather than a dollar amount. A company may have $75,000 of working capital, but if their current assets and current liabilities are in the millions of dollars, that could be a slim margin between them. The ratio puts the dollar amounts we see on the balance sheet into perspective.
The key to understanding the current ratio begins with the balance sheet. As one of the three primary financial statements your business will produce, it serves as a historical record of a specific moment in time. While the balance sheet does not show performance over time, it does show a snapshot of everything your company possesses compared to what it owes and owns. This is why there are several useful liquidity ratios that can be calculated, like the current ratio.
To calculate the current ratio, you’ll want to review your balance sheet and use the following formula.
Current Ratio = Current Assets / Current Liabilities
Within the current ratio formula, current assets refers to everything that your company possesses that could be liquidated, or turned into cash, within one year. As opposed to long-term assets like property or equipment, current assets include things like accounts receivable and inventory—along with all the cash your business already has.
Current liabilities, on the other hand, includes any expenses that will be paid out in the next year. This includes accounts payable, payroll, credit cards, and sales tax payable, among other items.
In dividing total current assets by total current liabilities, you’ll find out how much of your current liabilities can be covered by current assets. A result greater than one signals that you are in a strong position to pay off current liabilities. Anything lower than one might warrant some concern.
For example, if your business has $200,000 in current assets and $100,000 in current liabilities, your current ratio would be 2. This means that you could pay off your current liabilities two times over.
$200,000 / $100,000 = 2
If we swap these and say that you have $100,000 in current assets and $200,000 in current liabilities, you’d wind up with a current ratio of 0.5. This means that if all current assets were liquidated, you’d be able to pay off about half of your current liabilities.
$100,000 / $200,000 = 0.5
What Is a Good Current Ratio (Working Capital Ratio)?
As the examples above show, a low current ratio could spell trouble for your business. But when it comes to evaluating your company’s ability to pay off short-term debts, is higher always better?
As a general rule of thumb, businesses should aim for a current ratio higher than one. This means that they’re in a strong position to pay off short-term liabilities.
However, the more current assets you accumulate (and the higher your current ratio), the more you may want to consider reinvesting some of it into the growth of your business. High current assets are a signal that cash inflows are coming, so now might be the time to examine your options for growth.
Ultimately, a “good” current ratio is subjective and depends on your business and the industry in which you operate. What’s important is keeping an eye on this ratio regularly to ensure it stays within your comfort zone.
Because it relies on the preparation of your financial statements before it can be accurately calculated, the most frequently you’ll be able to check back will be once a month. If you’re currently only looking at financial statements once a year, consider increasing the frequency to quarterly at a minimum, though once a month would be ideal. This allows you to pay close attention to changes in metrics like current ratio and to make any adjustments you need to to keep it from dipping too low.
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Other Financial Ratios to Consider
There are several financial ratios that can be calculated using the balance sheet, many of which may be equally helpful in evaluating your business’ health. Here are some of the most common.
- Quick Ratio: The quick ratio also goes by the name “acid-test ratio” and is similar to the current ratio. The main difference? The quick ratio does not take inventory into consideration. As its name implies, the quick ratio focuses on items that can be liquidated very quickly. Since business owners can’t necessarily predict when they’ll sell through inventory, it’s excluded here.
- Debt-to-Equity Ratio: This ratio divides total liabilities by total shareholder equity. The goal of this ratio is to help businesses understand how much they owe in comparison to what they own. It’s a helpful measure of a company’s liability.
- Debt-to-Asset Ratio: This one divides debt (both short-term and long-term debt obligations) by total assets, showing to what degree a company’s assets were funded by debt.
Together, these ratios help a business owner review their finances from several different vantage points. Again, the results are in practice. The more you review these metrics, the easier it will be to spot changes or irregularities.
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Insert current assets and current liabilities totals from your most recent balance sheet to calculate the current ratio.
In most cases, a current ratio that is greater than 1 means you're in great shape to pay off your liabilties. However, there may be reasons for a lower current ratio. Read below to learn more about where your business stands.