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Learning how to calculate the current ratio can give you an excellent insight into your firm’s short-term liquidity. That’s important, because if you don’t have a good grasp of the solvency of your business, you won’t be able to maintain an accurate picture of your company’s financial health. Find out more about the current ratio with our comprehensive guide. Firstly, what is the current ratio?
Current ratio definition
The current ratio, sometimes referred to as the working capital ratio, is a liquidity ratio that you can use to determine whether the assets that you’re holding (which can be converted to cash within a year) are enough to pay off your current liabilities (that must be paid off within a year). In other words, it’s a financial metric you can use to evaluate your ability to pay your short-term obligations.
There are several other liquidity ratios that you may encounter when researching the current ratio, but it’s important to remember that these ratios measure slightly different things. The quick ratio is used to determine whether your company’s quick assets (assets that are convertible to cash within 90 days) are enough to pay off your current liabilities. The cash ratio looks solely at cash and cash equivalents.
Now that you know a little more about the current ratio and what it means for your business, let’s explore how to calculate the current ratio.
How to calculate the current ratio
You can calculate the current ratio using the following current ratio formula:
This is a relatively simple equation, so let’s break it down. Current assets refer to assets that can reasonably be converted to cash within a year. This means accounts receivable, inventory, prepaid expenses, marketable securities, cash, and cash equivalents. Current liabilities are short-term financial obligations, including accounts payable, short-term debt, interest on outstanding debt, taxes owed within the next year, dividends payable, etc.
You should be able to find your business’s current assets and current liabilities on the balance sheet.
What is a good current ratio?
To a certain degree, whether your business has a “good” current ratio is determined by industry type. However, in most cases, a current ratio between 1.5 and 3 is considered acceptable. Some investors or creditors may look for a slightly higher figure. By contrast, a current ratio of less than 1 may indicate that your business has liquidity problems and may not be financially stable.
However, you should remember that a higher current ratio doesn’t always mean that your business is in a healthier financial position. For example, a current ratio of 9 or 10 may indicate that your company has problems managing capital allocation and is holding too much cash in its accounts. From a business perspective, that cash would be better spent on investments or growth initiatives.
Limitations of the current ratio formula
Although the current ratio can be immensely helpful, there’s one clear limitation. When you calculate the current ratio, you’ll need to include relatively illiquid assets (assets that can’t easily be converted into cash) such as inventory or accounts receivable. As such, the current ratio formula may not be the best metric to use for determining your business’s short-term liquidity.
Besides, the current ratio may not give you an accurate picture of your business’s liquidity if you’re a seasonal business, as assets/liabilities are likely to vary wildly depending on the period selected. As such, you should look at the current ratio over a more extended period to get a more accurate sense of your accounting liquidity and the proportion of your current assets to liabilities.
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