Businesses need to keep a keen eye on what they own and what they owe. Even more importantly, they need to focus on their ability to pay down those debts in the immediate future.
To do this, you could start counting up every dollar and every outstanding bill, but this simple tallying misses some of the details of the situation. And on your balance sheet, you’ll have long-term debts as well as assets that can’t be easily converted into cash.
Instead, businesses use the current ratio to understand this all important balancing act of owning and owing at a glance. This is what you need to know about this measure of financial health.
What is current ratio?
The current ratio (or working capital ratio) is a financial metric that measures the business’s ability to pay down its debts by looking at its current assets and current liabilities.
As with all financial ratios, the current ratio is a quick measure of something complex to be understood at a glance. By weighing current assets against current liabilities, someone could understand whether a business can afford its debt level simply by checking whether the current ratio is greater than 1.0.
This ratio is typically used to understand a business’s financial health, as well as its liquidity (the ability to generate cash to pay down liabilities).
Components of the current ratio
There are two components of the current ratio: current assets and current liabilities.
Current assets are what the business owns that is either held in cash or could be turned into cash within a year. Common examples include cash on hand, accounts receivable, and inventory.
Current liabilities are what the business owes that are due to be paid back within a year. Common examples include accounts payable, tax payable, and salary or wages owed.
The emphasis on both is to look at things that only affect the short-term (next 12 months) operations of the business. For any long-term debts, it’s optional to include the current component of that debt (i.e. the next 12 months of payments).
You may already be tracking current assets and current liabilities separately on your balance sheet as they’re parts of GAAP reporting practices.
What does current ratio tell you about your business?
In short, the current ratio tells you whether the business has enough short-term assets to cover its long-term debts. But what exactly does that mean?
If the short-term assets are greater than the short-term liabilities, then the business is seems as having enough capital that it could pay down its debts if it liquidated (or sold off) all of its assets.
This means the business isn’t at risk at defaulting on its liabilities, even in a worst-case scenario of sales revenue or cash inflows dropping to zero. But it also helps you understand the business’s ability to invest its capital.
Generally speaking, a “good” current ratio is considered to be within 1.5 and 2.0. If your current ratio is greater than 2.0, the business could have a surplus of capital that isn’t being used effectively.
Any short-term assets in surplus of a 2.0 current ratio represents an opportunity to put that money back into the business with new purchases, like equipment or software that could increase efficiency.
Current ratio formula: How to calculate current ratio
The current ratio formula is a simple equation dividing current assets by current liabilities. As an equation, the current ratio formula is:
There are three potential outcomes from the formula:
- If the current ratio is less than 1.0: The business currently owes more than it owns and a cash injection may be needed to keep the business afloat in the short-term
- If the current ratio is between 1.0 and 2.0: The business is generally considered to be healthy since it owns more than it owes.
- If the current ratio is greater than 2.0: The business has an excess of capital relative to its debt and should look for opportunities to reinvest it.
Keep in mind these are some general rules of thumb that don’t consider a business’s specific industry, growth stage, or goals. For example, a startup could stomach a current ratio below 1.0 knowing that it has investment coming through.
Current ratio example
A business is looking to make an investment in the equipment it uses in the production process. The purchase amount would be $5,000.
Before it commits to the purchase, the business takes stock of what it owns and owes in the short-term to see if they have capacity for a purchase of that scale.
They start by looking at their current assets and current liabilities to calculate their current ratio. The tally of both is as follows:
By plugging the values into the current ratio formula, they get:
Current Ratio = 12,700 / 10,500
Current Ratio = 1.21
In their current state, they have a healthy current ratio where they can afford all of their short-term debts and have money left over.
If they were to buy the equipment, they would do so using their cash on hand. They update their analysis with what their numbers would be after the purchase:
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By plugging in their updated numbers into the current ratio formula:
Current Ratio = 7,700 / 10,500
Current Ratio = 0.73
Purchasing the new equipment outright would push the business into an unhealthy current ratio number, putting them at risk of being unable to cover their liabilities in the short-term future.
To afford the new equipment, the business may want to consider looking into financing options to keep their current assets balance high enough for a healthy current ratio number.
Current ratio vs other liquidity ratios
The current ratio is one of many liquidity ratios that businesses use to understand their financial health at a glance. Here’s how the current ratio compare to the other three liquidity ratios.
Quick ratio
The quick ratio is very similar to the current ratio except it looks at only the most liquid of assets that can be immediately turned into cash. This means the quick ratio does not include some current assets like inventory or prepaid expenses, both of which cannot be easily turned into cash at a moment’s notice.
The quick ratio formula is:
It’s most likely that the quick ratio will be lower than the current ratio and is thus a more conservative measurement. It’s favored by businesses that have long sales cycles for inventory or a long time to collect payment on their accounts receivable.
Cash ratio
Even more conservative than the quick ratio and current ratio is the cash ratio. The cash ratio only considers the balance of cash and cash equivalents weighed against current liabilities.
The cash ratio formula is:
For businesses that are concerned about their ability to turn their current assets into cash, the cash ratio is the clearest picture of how effectively a business can pay down its short-term debts.
Given that only cash and cash equivalents are being considered, there’s no noise in the equation that could affect the ratio (such as liquidating inventory requiring selling stock at a below market rate).
Days sales outstanding (DSO)
Days sales outstanding is unique from the ratios we’ve discussed so far as it doesn’t look at assets and liabilities. Rather, it’s a measurement of the average numbers of days it takes for the business to collect payment on an invoice or sale.
The days sales outstanding formula is:
This ratio is specific to businesses that invoice all their sales and is typically calculated on a quarterly or annual basis. With this information, they can tell how much of their cash gets held up in accounts receivable and for how long.
Common mistakes with the current ratio
Working with the current ratio helps you understand the financial health of a business better, but only if you avoid these common mistakes.
Incorrectly classifying current assets or current liabilities
There’s much to learn from tracking the current ratio, but only if the current assets and current liabilities are correctly categorized. Remember that for anything to be considered “current,” it must have a balance that’s realized within the next 12 months.
If you’re ever in doubt with what should be included, consult with a financial professional. Once you get the setup done correctly the first time, it’s easily repeatable.
Using the wrong benchmark
The rule of thumb is that a “good” current ratio is greater than 1.0 and that 1.5 to 2.0 is the target to aim for. The problem is this rule of thumb ignores the context of industry, size, and other unique aspects of the business.
Say the business is servicing long-term debts. If they have a current ratio of 1.0, they have enough assets to cover the short-term, but what about beyond that?
It’s important to set goals for the current ratio, but it should come from an equal consideration of industry norms and the unique aspects of the business.
Ignoring the timing of assets and liabilities
Consider a business that has $10,000 in accounts receivable and $10,000 in accounts payable. On paper, they have enough assets to cover their liabilities.
However, if you were to add in that the accounts payable is due on the 10th and the accounts receivable is due on the 20th, that’s a cash flow issue.
The current ratio provides a general picture, but you should also be mindful of your cash flow management to understand when cash is entering and exiting the business.
Overreliance on the current ratio
Looking at just the current ratio can lead you to the wrong conclusions. You should also be tracking and setting goals for the quick ratio and cash ratio to get more conservative estimates of the business’s liquidity.
Aiming for a high current ratio
The current ratio is one metric where higher doesn’t always mean better. If the business is holding a surplus of assets, it’s missing out on opportunities to reinvest that capital into their business.
When faced with a large current ratio, consider looking at it from the perspective of “how much can we spend while keeping the current ratio healthy.”
For example, if you have a target ratio of 2.0 with $25,000 in current assets and $10,000 in current liabilities, you could spend $5,000 while still hitting your current ratio target.
Tying Current Ratios To Your Budgets
The current ratio is made up of current assets and current liabilities. If you want to control your current ratio, you’ll want to control each of these factors.
Current liabilities are hard to control, but there are many things you can do to protect your current assets, including using a budget. By controlling what you spend and where your money is going to, you can hold onto more of those current assets.
With BILL Spend and Expense, you get access to an expense management software and company cards that help you control what you spend. That means complete oversight and control over every dollar that leaves the business.
Reach out for a demo to see how we can help you hit your budget goals and get the most out of your assets.
