Learn what a current ratio is and why it is so important to understand when evaluating the health and future of a company. See how the ratio is calculated and what components go into this important figure.
If you ask a panel of experienced entrepreneurs or business experts why most businesses fail, you will likely notice the same answer coming up over and over. One of the biggest reasons businesses fail is because they don’t have enough cash on hand to satisfy their short-term operating expenses. These businesses may have had a great idea, a great location, and some great people on their team, but they didn’t manage their short-term cash needs effectively and failed. When accountants, top-level executives, and financial analysts want to make sure a company is on solid ground, there are a few quick things they can look at. One of those financial metrics is known as a current ratio.
The current ratio is a measure of how well a company can meet its short-term obligations. Short-term obligations are usually debts or liabilities that need to be paid in the next twelve months.
In accounting terms, the current ratio is the ratio of current assets to current liabilities, and is often described as the liquidity of a company. To be classified as a current asset, the asset must be cash or able to be easily converted into cash in the next 12 months. Current liabilities are any amounts that are owed in the next 12 months. For a more advanced understanding, we recommend additional study of the individual components that make up current assets and current liabilities. It’s important to note that the current ratio may also be referred to as a liquidity ratio or working capital ratio.
The current ratio formula is calculated as follows:
Current Assets/Current Liabilities
Current Assets = Cash + Accounts Receivable + Inventory + Prepaid Expenses
Current Liabilities = Short-term notes payable + Accounts Payable + Payroll Liabilities + Unearned Revenue
In the most simple terms, the current ratio helps internal and external individuals see how likely the company is to have issues paying its bills. Remember, this is one of the main reasons companies fail. The higher the current ratio, the better positioned the company is to operate smoothly in the future and have no issues paying their bills in the next 12 months.
A ratio over 1 means that a company has some cushion to handle potential unforeseen expenses that might arise. As an employee, looking at the current ratio might be a good idea to let you know whether your future paychecks are safe. A ratio under 1 implies that if all the bills over the next 12 months came due immediately, the company would not be able to pay them all off; only a percentage of them. To get a better idea of this in action, let’s look at an example.
If a company’s current assets are $100,000 and its current liabilities are $50,000, the current ratio is 2:1. This means that if all the bills for the next year came due tomorrow, totaling $50,000, the company could pay them all off twice, with its $100,000 in assets. This gives investors and managers assurance that the company is in a good position to pay the bills.
If the current assets are $100,000 and the current liabilities are $300,000, the current ratio is 1:3. This should raise concerns that the company may have a hard time meeting its short-term obligations. They may only be able to pay 33.3% of their bills if they all came due. This certainly doesn’t mean that a company will go bankrupt, but is simply something to be aware of and investigate further.
The current ratio is a measure of how well a company can meet its short-term obligations. It is the ratio that is calculated by dividing current assets by current liabilities and is often described as the liquidity of a company. A ratio under 1 implies that if all the bills over the next 12 months came due immediately, the company would not be able to pay them all off; only a percentage of them. A ratio over 1 implies that the company has a little extra cushion for unforeseen events and is more strongly positioned to face any challenges that might arise.