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What is the Current Ratio? How to calculate it and use it for your business?
The current ratio is commonly used to allow business owners to access the liquidity of their company. It evaluates if a company is liquid enough to cover its short term liabilities.
What is the Current Ratio?
The current ratio, also known as the general liquidity ratio or working capital ratio, is a metric used to evaluate a business’ capacity to honour short-term financial obligations. In finance & accounting, short-term liabilities are those a business has to pay within 12 months.
The current ratio takes into account both current assets and current liabilities. It’s a useful metric for a business such as supermarket or restaurant. That’s because these types of businesses sell many of their products within a few days. That means they turn their stock into cash - fast.
A quick note:
Don’t confuse the current ratio with the quick ratio! They both evaluate the liquidity of a company - but there is an important difference. The current ratio accounts for stock, the quick ratio does not. That’s why the current ratio is a great metric for a supermarket, but the quick ratio may be better suited to an art dealer.
Why is the Current Ratio important for your business?
There are several reasons why your business may find it important to analyse its current ratio, such as:
- To inspire confidence in banks & investors. A strong current ratio proves you have enough liquidity to pay back short-term liabilities. This means less risk involved in investment!
- The current ratio can be used to benchmark your business against competitors. How healthy is your liquidity situation compared to the industry averages?
- Access whether your debtors are paying you back in good time and what the impact may be of slower or faster payback times.
- Access whether your stock is generating enough cash (liquidity). If your current ratio is weak, you could sell off stock to inject cash into your business.
Now that we have seen what the current ratio is and why it’s important, it’s time to see how it’s calculated!
How do you calculate the current ratio?
To calculate the current ratio, you must compare your current assets to your current liabilities.
Current assets
Your current assets include your bank balances, accounts receivable (money you’re still owed!), your liquid assets (available cash) and your inventory.
Current liabilities
Your current liabilities are the financial obligations that must be honoured within the next 12 months. This includes bank loans, accounts payable (money you owe to others), wages, lease payments and outstanding taxes payable.
The current ratio is calculated as:
CURRENT ASSETS ÷ CURRENT LIABILITIES = CURRENT RATIO (X : 1)
Things to look out for why analysing your current ratio
When it comes to the current ratio, it’s generally the higher the better. But be sure to account for a few things while interpreting it:
- A current ratio below 1 means that your company has more debt than liquid assets. That means that there is a chance of running into liquidity problems in the near future.
- A current ratio of 1.5 is considered to be the norm, but it really depends on your sector and business type. It’s therefore good to compare your results to others in your industry.
- It’s also worth remembering that a very high current ratio is not always a sign of a healthy business. Too much liquidity often means that the cash could be being put to better use, such as an investment.
Interview with La Khey de la compta - "The Accountancy bro"
How would you describe the current ratio to a young entrepreneur?
You will read online that a ratio greater than 1 means that the company is able to finance its current liabilities with its current assets, so it's all good. A ratio less than 1 means the opposite... That’s great, but what does that actually mean!?
This is the type of indicator you might want to avoid looking at when starting a business, unless you enjoy insomnia and cold sweats.
At the beginning of your business, expenses are often all you have! Creating the company, putting stocks together, heavy investments… Debts pile up quickly!
At the same time, the first sales are poppin! But the money owed to suppliers, state and lenders have the bad tendency to progress quicker than your receivables.
So your ratio might tend to be below 1. Tough… Sure! But in this phase of your company's life this is not abnormal. Come on, let’s stay focused on the future and turn the tide!
What about a more mature company?
They will tend to have reached a certain cruising speed, just like their leader's private jet! Therefore, they have more visibility over their financial management.
For more mature businesses, it's not just about being able to pay current liabilities with current assets. The goal is having a comparable ratio with companies in the same sector and of the same size!
Don't aim for a ratio that goes through the roof! That would mean your company is just sitting on its hard earned money! If your account is full of this sweet cash money, it could be invested to make even bigger bucks!
How is a current ratio best used?
The current ratio is best for you when your business has reached its cruising speed! Don't nap just yet! You will then enter the creation phase, the growth phase, or any phase that involves unusual variations in liquidity. This ratio will momentarily lose relevance. Like on Youtube or Tiktok when you don’t unfollow, but you unring the notification bell! This indicator is therefore to be used with all this in mind.