There are many ways to take the temperature of your business’s success level. However, one of the best-known is also often misunderstood and overlooked.
Take some time to learn about the definition of a current ratio, as well as how it can help you gauge how well your company is performing.
What is a current ratio?
The term, defined by calculating current assets to current liabilities, measures the adequacy of a company’s assets that can be converted into cash to pay off short-term obligations.
Ideally, a company should have sufficient assets (cash and near-cash assets that can be converted into cash) to pay off any short-term debts or obligations due within one year. The current ratio is determined by using the balance sheet to divide current assets by current liabilities.
Assets include inventory, accounts receivable, prepaid expenses, marketable securities, cash, and cash equivalents. Liabilities include accounts payable, short-term debt, taxes owed within the next year, interest on debts, and dividends payable. Keep in mind that liabilities also include fees from your merchant provider.
Generally, an acceptable current ratio falls somewhere between 0.5:1 and 2:1, depending on the industry in which the business functions. If the ratio is within this range, it suggests that the company has sufficient money or assets on hand to satisfy its obligations as they fall due, without sacrificing too much working capital.
For example, a current ratio of 1:1 means that current liabilities can be fully paid using present assets even if they all come due simultaneously. A current ratio of 2:1 indicates that current liabilities can be paid twice over out-of-present assets.
The importance of trends.
The current ratio should be viewed in light of past time periods, competitors, and industry benchmarks as a whole.
A current ratio should always be viewed in context. Therefore, it is vital to pay attention to how the ratios change over time, as well as trends that are occurring in the industry that can affect this data point. Using tools such as a real-time reporting system can give you a way to more accurately gauge these patterns as they are being shaped.
You can take the pulse of your business by viewing these patterns. For instance, a current ratio that decreases year-on-year, or one that falls below industry standards, might suggest that your company is having liquidity difficulties.
On the other hand, a ratio that is too high, while it heralds success, might also point to faulty management of working capital, tying up more funds in the business than is necessary. This could stem from excessive inventory, subpar credit management, or poor use of surplus cash.
Other liquidity ratios.
The current ratio is just one of the ways that companies measure their liquidity. Others include the quick ratio and cash ratio.
As you look into information about the current ratio, you will find similar metrics that actually measure slightly different things.
For instance, the quick ratio shows you whether your quick assets (the ones that can be converted into cash in 90 days) are sufficient to pay off your current liabilities. The cash ratio looks only at cash and cash equivalents.
Limitations of the current ratio.
The chief limitation of the current ratio formula is that it requires you to include assets like inventory and accounts receivable that cannot easily be converted into cash. This makes determining short-term liquidity problematic.
In particular, seasonal businesses may not benefit from the current ratio. This is because both their assets and their liabilities vary greatly according to the time of year. This type of store may even need to resort to obtaining fast funding to meet the financial needs that arise from this unpredictability.
The current ratio metric can be a valuable way to gauge your business’s present solvency. A figure that is either too high or inordinately low can be a strong predictor that can guide you toward taking corrective steps that can keep you on a smooth fiscal course.
If you haven’t taken the temperature of your business lately, we encourage you to get out your balance sheet and calculator to gain valuable insights that you may be able to use right away to promote long-term success.
North is a leading financial technology company that builds innovative, frictionless end-to-end payment solutions designed to simplify and grow businesses of all sizes. From the front door, to the back office, the developer world, and partnerships that expand the payments landscape, North offers proactive, comprehensive merchant services, in-house processing, and more.
