Evaluating a company’s financial health can be difficult without the right metrics. Current Ratio is an important concept to understand and apply to your business. Investors, analysts, managers, and business owners can gain greater insight to the health of their company’s short-term financial obligations by using Current Ratio along with other helpful accounting metrics.
In this post, we’ll explore what is Current Ratio, how to calculate it, and how to interpret the results.
What Is Current Ratio?
Current Ratio measures the ability of a company to pay it’s short-term liabilities with its current assets. Short-term refers to liabilities due within one year and current assets includes assets expected to be converted into cash within one year. Essentially, the question you are hoping to solve is – Could your company settle all of its short-term debts today by only using its short-term assets? In even simpler terms, the Current Ratio measures your company’s liquidity to cover short-term debt.
What Is The Current Ratio Formula?
Current Ratio = Current Assets / Current Liabilities
Current Assets
- Cash
- Accounts Receivable
- Inventory
- Prepaid Expenses
- Marketable Securities
Current Liabilities
- Accounts Payable
- Accrued Expenses
- Short-Term Loans
- Current Portion of Long-Term Debt
Simple Example of Current Ratio
Benjamin’s owns a small business that sells cell phones cases via a retail store. He’s unsure how well it is really doing. The revenue is increasing each month, but he’s also adding new costs. His main goal is for the small business to grow conservatively without putting it at risk due to a sudden economic downtown.
Let’s take a look at Benjamin’s small business.
Current Assets: $150,000
Current Liabilities: $50,000
This means Benjamin’s small business has a Current Ratio of 3.0 ($150,000 / $50,000). Another way to think of this is Benjamin’s small business has $3 in current assets for every $1 in current liabilities. This is a higher than normal Current Ratio for most businesses. Benjamin’s small business has enough available liquidity to invest in new growth opportunities and/or increase inventory. In fact, his cell phone case business is likely missing opportunities by not utilizing this liquidity better.
Good vs Bad Current Ratio
While a good/bad Current Ratio varies by industry and company lifetime, in general most businesses should fall within 1-2.
- Below 1.0 = Not have enough current assets to pay current liabilities.
- 1.0 to 2.0 = More stable with its current financial obligations.
- 2.0 to 2.5 = Solid short-term financial footing
- 2.5 to 3.0 = Some excess short-terms assets that might be used for growth or improvements.
- Above 3.0 = Excessive short-term assets might indicate ineffective use of company funds.
Limitations of Current Ratio
Every business is different and it’s vital to understand your full financial story. Things like seasonality and changes in purchasing patterns can affect Current Ratio calculations.
Many businesses have large swings in their seasonality with months of high sales and months of low sales. The Current Ratio of your business might look low in September, but be stable in January. Charting your Current Ratio monthly is a great way to see trends and put your mind at ease when seasonality affects your business.
For some heavy inventory businesses, such as ecommerce companies who do not utilize drop-shipping, changes in purchasing patterns also limits the usefulness of Current Ratio. The liquidity of your inventory (current assets) might not fit historic patterns you have seen each year. What happens if you have the wrong products in your inventory? They won’t sell like you normally expect, which means that inventory you are thinking of as a current asset isn’t actually going to help you cover your current liabilities. A good variation to use for a business like ecommerce is Quick Ratio.
Summary of Current Ratio
Current Ratio is a basic metric to analyze the short-term health of your business. It is useful to chart monthly, which helps you see changes in your short-term financial health over time and notice any unforeseen things year over year. There are, however, limitations to Current Ratio and it should not be solely relied on. Think of Current Ratio as the scale in your bathroom. There are many reasons why the scale moves up or down, but ideally you anticipate those movements and are not caught off guard when your clothes no longer fit.