Liquidity is essential to a financially healthy business. The more ready cash you have to cover your debt repayments, rent, employee salary, utilities, and other fixed expenses, the less you have to worry about cash-flow crises that could stymie your operation.
The current ratio (also known as the liquidity ratio) measures how well a company is able to meet its short-term obligations such as fixed operational costs and short-term debt.
It is called the current ratio because it takes into account all current assets and current liabilities. The higher a company’s current ratio, the more working capital it is able to access.
Current ratio formula
Calculating a company’s current ratio involves comparing the current assets on its balance sheet to its current liabilities.
Current assets include:
- accounts receivable
- anything else likely to be liquidated within one year
Current liabilities, on the other hand, include:
- accounts payable
- taxes payable
- employee wages
- short-term debts
- the current portion of longer-term debts (such as mortgage payments or vehicle finance)
Working out your liquidity ratio takes time and effort, but it’s absolutely essential knowledge for SMEs. Without it, business owners are flying blind when it comes to their free cash flow. If it dries up, they may need to rely on high-interest borrowing to cover operational expenses and debt obligations in the short term. Fortunately, automated tools can take both the legwork and the guesswork out of understanding your business finances.
What is a good current ratio for my company?
A good current ratio will depend on your industry, and the size of your business. Some business models have inherently higher current liabilities and operational expenses than others, while larger companies typically have higher current ratios because they command greater revenues.
By rule of thumb, if a company’s current ratio is above 1.00, it has sufficient current assets to cover its current liabilities. If a company’s current ratio is 1.50 or above, it has ample working capital to cover all current liabilities.
However, it’s important to remember that a current ratio is just a snapshot of how a business is doing at any given moment. If a current ratio falls below 1.00, that does not mean that its ratio will not improve.
Frequently asked questions about current ratio
What’s the difference between the current ratio and the acid test ratio?
Current ratio is often compared to other liquidity ratios such as the acid test ratio. In fact, at first glance, there’s very little difference between these two ratios.
The only real difference is that an acid test ratio does not include inventory and prepaid expenses which may take slightly longer to liquidate than other current assets like cash or accounts receivable.
Is using current ratio limiting?
Using the current ratio has some limitations. It is only a snapshot and cannot account for upward or downward financial trends. It can also be limiting when comparing your business to others in different industries, as some sectors have inherently higher current ratios as their business models require a large proportion of current assets.
Do current ratios change?
Yes, absolutely! And how quickly they change may be viewed by analysts as an indicator of your company’s financial well-being. A company may have a good current ratio at the start of the year, but struggle to pay off its bills and debts by year-end. Likewise, a company may have a current ratio below 1.00 by the start of the quarter, but achieve a more favorable ratio by the end of the quarter if it is able to pay off its current liabilities quickly by increasing revenues.