The current ratio is an essential metric that small business owners, in particular, should keep a close eye on for their own company. It is also necessary for an investor to understand the current ratio in multiple companies when purchasing stock.
What Is the Current Ratio?
The current ratio is a commonly used metric in business, known as the working capital ratio. Generally speaking, the current ratio is a way of evaluating a particular company’s ability to pay short-term obligations.
What Is a Short-Term Obligation?
When looking at the current ratio, a company’s short-term obligation refers to any company’s payments within one year.
The current ratio compares assets within a company that can be converted to cash within a year to the liabilities it is also responsible for paying off within a year.
There are a few different liquidity ratios, the current ratio being one of them, that measure a company’s capacity to use its cash to meet the short-term financial needs. Other examples of liquidity ratios include:
- Quick ratio, or acid test
- Cash ratio
How Do You Calculate the Current Ratio?
You can calculate the current ratio of any company by dividing its existing assets by its current liabilities. The number this formula produces is the current ratio, which is equivalent to the number of times a company can pay its current financial obligations with its available assets.
The current ratio is significant because the higher the number produced from the formula is a vital indicator of the strength in the company’s current financial position.
Current Ratio = Current Assets / Current Liabilities
According to the balance sheet of a company, there are multiple different current assets. Current assets include:
- Cash equivalents
- Accounts receivable
Cash equivalents, which are considered a current asset, are different types of investments that will mature in less than three months and convert easily to cash. Examples of cash equivalents include:
- Government bonds
- Commercial paper
- Money market funds
Accounts receivable refers to the money that another company owes the primary company.
Inventory includes the complete product within a company and the material used to create it.
On the other side of the ratio is current liabilities, which include:
- Accounts payable
- Income taxes payable
- Wages payable
- Dividends declared
Accounts payable are the amounts a company owes to suppliers at any given time.
Income Taxes Payable
Income taxes, much like individuals, are the taxes a company owes to the federal government.
Wages payable include any wages that have been earned by employees but not yet paid by the company.
Dividends approved and declared by the company’s board of directors but have not yet been paid are known as dividends declared.
How Does the Current Ratio Work?
As a rule of thumb, investors look at current ratios below one to mean that the company might run out of money within the year. Alternatively, if they can show that they can increase cash flow or obtain additional investment capital, they might have the ability to sustain longer.
A higher current ratio in a company typically means no short-term liquidity concerns, which is a good thing for small business owners. An ideal current ratio for a company is two; a comfortable financial position for a company to be.
Keep in mind that acceptable ratios tend to vary amongst different industries. If you are dealing with industrial companies, a 1.5 may be adequate.
Some investors might believe that a company with a high current ratio is hoarding cash and not paying off dividends or reinvesting the money.
What Are the Limitations of the Current Ratio?
There are limitations when calculating the current ratio of a business. It is essential to look at each of them when determining whether it is a useful metric for your company.
1. Cash Conversion of Current Assets
One of the limitations involves accounts receivable and inventory. Because both current assets are not easily converted into cash, it is difficult to accurately determine a company’s short-term liquidity.
Instead of using current assets, the cash ratio looks at cash and cash equivalents only. Because these are the most liquid assets within a company, it can eliminate some of the limitations found when using the current ratio.
2. Business Seasonality
Additionally, for highly seasonal companies, the current ratio might not accurately depict the company’s liquidity.
3. Comparing Business to Business
Another limitation found in using the current ratio occurs when comparing businesses. Because there can be substantial differences amongst companies across different industries, it can become difficult to compare two against each other via the current ratio.
How Do You Calculate the Current Ratio in Excel?
There are multiple different Excel templates out there that will quickly help you keep track of your assets and liabilities. These templates will quickly calculate your current ratio at any given time, depending on the amount of information you provide.
An alternative way to calculate your current ratio in Excel would be to use the simple division formula. Place your current assets total in one cell, your current liabilities in another, and calculate the current ratio in another cell.
Ex: Current assets in cell A1, current liabilities in cell A2. In cell A3, type “=A1/A2” and hit [return] to calculate. The number in A3 will be your current ratio.
While the current ratio is a helpful metric for small business owners and investors, it is crucial to understand some limitations when calculating this figure. If your existing assets are challenging to convert into cash or if your business is highly seasonal, it might be worth it to look into alternative liquidity ratios.
Otherwise, use the current ratio as a way of identifying your ability to pay off your short-term obligations. The ratio itself is simple to calculate, and the number you are looking for would be one or higher to prove that you can pay off your financial obligations.