Every small business owner needs to figure out his company’s solvency – its ability to bring in enough revenue to pay its bills and still realize some profit. Solvency is important because it can be a gauge of whether a company’s general health is good if it can obtain credit, and if it should consider expansion. When a company becomes insolvent, that is, it cannot meet its financial obligations, then it must close its doors. There are levels of solvency that are clear indicators of a company’s financial health. One key figure to look at is what is called the current ratio.
What is Current Ratio?
Put simply, current ratio can be defined as a proportion of a company’s assets to its liabilities. This is usually a short-term measure of liquidity.
The current ratio figure provides you with a better idea of how many dollars you have in the current assets to cover each dollar of debt or other liabilities such as taxes, accounts payable, employee salaries and so on. Again, this is a short-term measure and is generally used to make sure you can stay in business for at least the next year. So it’s a bit more long-term than quick ratio and also accounts for inventory.
Current ratio is obviously a critical figure to have. If your number looks good, you can sleep at night. If it’s not good, that is, if you do not have enough assets to cover your liabilities, then you have to take immediate action to correct the situation, so you can remain solvent.
One important point to note, though: there may be times in a year when your ratio is bad but corrects itself well during ensuing months. A typical example may be a seasonal business with hills and valleys in some of its assets (e.g., cash on hand). If your low ratio was at the same level at the same time in the previous year and then became healthy two months later, it is likely that the same will happen this year too. Consider a swimming pool servicing company during the winter months as an example.
How to Calculate Current Ratio
The current ratio formula is quite simple:
Current ration = your current assets ÷ current liabilities.
So, if you have $300 in assets and $100 in liabilities, your ratio is 3.0.
But as is the case with most financial accounting, the devil is in the details. And those details can tell a variety of stories and have a variety of interpretations. So let’s unpack each term and its implications for better clarity.
Current assets obviously include cash on hand as well as investments, accounts receivable, your inventory, etc. – anything that has a cash value.
Current liabilities are accounts payable, deferred revenues, compensation, accrued income taxes, and other accrued expenses, portions of long-term debt, and short-term debt
You also have to attach a cash value to non-cash types of assets, such as inventory. If you were to liquefy that inventory, what would you get? Jot down that number.
Now let’s move to a quick example illustrating how to find current ratio for your business.
Sample Current Ratio Calculations
Let’s look at a Company X that has $300,000 in current assets and $200,000 in current liabilities. Taking 300 ÷ 200 = 1.5 current ratio.
This is a healthy current ratio because the company has $1.50 in assets for every $1.00 it owes.
Now there’s Company Y. It has $200,000 in assets and $200,000 in debt. 200 ÷ 200 = 1.0 current ratio. This company is just breaking even. For every $1.00 in assets, it has $1.00 in debt. Okay, but certainly not great. Company Y should probably attempt to increase its revenue and/or profit margins. It is unlikely that long-term lenders will look favorably on this situation if that ratio has been at 1.0 for a long time. The company cannot afford to take on any more liability.
Company Z has assets totaling $300,00 but current liabilities totaling $350,000. 300 ÷ 350 = 0.857. Company Z is not currently solvent. For every $1 of assets, it owes more than that dollar. If this has been a longer-term condition (rather than seasonal, for example), then Company Z will most likely fold.
Now, let’s take another two examples to see more detail.
Company X from above, we already saw has a current ratio of 1.5. Company XX appears to be in even better shape. It has assets of $400,000 and liabilities of $200,000, giving it a current ratio of 2.0.
Digging a bit deeper into these two companies, though, can provide a bit of a different story.
- Company X’s assets are all cash or cash equivalency, and that is a very healthy situation. There are no assets that have to be liquified in order to pay any of its debts.
- Company XX’s assets, however, are almost all tied up in inventory, not cash. The inventory will have to be sold to meet its debts. While that inventory has a cash value, that value is not guaranteed. It may have to be sold at less than the actual value in order to get the cash to pay its debts. That could lower the current ratio significantly.
What is a Good Current Ratio?
Obviously, the higher the ratio, the healthier and more solvent the company is. And the higher the ratio, the greater the opportunity a company has for growth and expansion, not to mention the ability to secure more financing for growth. 1.5 and above can be considered a good number, and getting up beyond 2.0 is great. But, again, it can vary at different times.
How often should you calculate your current ratio? Large enterprises have software that crunches the numbers on a daily basis. You can get this calculation through some accounting software as well and then set up a schedule for reporting. The more often you do this, though, the better, because it will allow you to take proactive steps to increase your cash assets if you see your ratio slipping.
Are There Limitations to Current Ratio?
The short answer is yes, there are. Using the basic formula and nothing else holds the following limitations:
- It does not provide the details, especially of assets, that can actually impact the ability to pay bills
- Taken in isolation, the current ratio does not give enough information about the company and other aspects of its operations.
- This ratio is subject to manipulation, especially in the valuation of non-cash assets, in order to provide a better ratio.
As with most accounting calculations for specific financial information, the current ratio tabulation is only one piece of information in a much larger financial picture. Is it an important calculation? Of course. As a small business owner, you need to know where you really stand vis a vis your assets and your debts, and you need to know it frequently. Your “wiggle room” is far less than larger enterprises, and you need to be proactive to ensure that you can pay your short-term debts.
Photo by Kelly Sikkema