One of the many reasons to keep your business accounting records organized and up to date is so you can easily analyze and understand the key performance indicators in your business that are vital to your success. Key performance indicators, or KPIs, use ratios and percentages to let you look beyond the dollar figures in your business and get to the heart of how you are truly performing. Although this might sound complicated and daunting, ratios really are a simple way to benchmark your business.
One of the most important KPIs you can understand is the current ratio. This easy-to-calculate metric quickly tells you how healthy your business’s cash position is. In this article, we’ll take a closer look at the current ratio, including what it is, how to calculate it, and how to use it to steer your business forward.
What Is the Current Ratio?
The current ratio is a measure of your business’s short-term liquidity, or your ability to pay your short-term bills and other debts. The current ratio is a division equation, with each side of the equation looking at different information: current assets and current liabilities.
You’ll find the current ratio information on your company’s balance sheet. This financial statement is a picture of what your company owns (assets) and what it owes (liabilities), and it shows your company’s financial position as of a certain point in time.
Assets are shown at the top of your balance sheet, and liabilities are shown below assets. Within each section of the balance sheet, the current numbers appear first, making it easy to find the information you need to calculate the current ratio in your business.
Broadly speaking, assets are what your business owns. Some assets are easy to convert to cash. Cash on hand and in the bank, stocks and bonds, security deposits, most accounts receivable, and inventory are all current assets. They are relatively easy to convert to cash, and so they are included in the current ratio calculation.
Other assets—like heavy equipment, buildings, and other fixed assets—are harder to convert to cash in a short period of time. These assets are not included in your current ratio calculation, because your bills and other short-term debts would likely come due before you could convert your fixed assets to cash by selling them.
Just as the current ratio focuses on the current assets in your business that can be converted to cash in a short period of time, it also focuses on the liabilities—or what your business owes others—that will be due in a short period of time.
Current liabilities—like accounts payable, payroll and sales tax liabilities, and the portion of a loan that is due and payable within the next 12 months—are included in the current asset calculation. Long term liabilities, like multi-year loans, are not.
The Current Ratio Formula
The current ratio formula is one of the easiest financial ratio formulas to remember and to use. It is:
Current Assets / Current Liabilities = Current Ratio
As mentioned, each of these numbers is subtotaled on your business’s balance sheet, making it easy to find the information you need to calculate your business’s current ratio.
There is one caveat here, though. The accounts receivable number on your balance sheet should only reflect amounts due to your company within the next 12 months or less. However, some businesses will include amounts due from large clients or contracts over more than one year in their accounts receivable. Other businesses enter contracts that aren’t actually billable yet into accounts receivable in order to keep track of them.
If your business follows either of these practices, you will need to exclude the long-term receivable amounts from your current ratio calculation. We also advise speaking with your accountant or bookkeeper for alternate ways to record these amounts so you can keep your financial statements clean while still tracking money that will eventually be due to you.
How to Calculate Current Ratio: An Example
Now, let’s illustrate how to calculate current ratio with an example.
Let’s say you own an independent retail pharmacy. You are located in a small town with an aging population, so you generously extend credit to your customers. This allows them to get their medications when they need them, and then they pay you when they receive their pension payments.
As of the end of the second quarter, your balance sheet shows the following information:
- Cash: $250,000
- Money Market Savings: $36,000
- Prepaid Expenses: $12,000
- Inventory: $530,000
- Accounts Receivable: $8,000 (all current and due within 30 days)
- Accounts Payable: $3,000
- Line of Credit: $17,000
- Building Loan Due Within 12 Months: $24,000
- Long-Term Building Loan: $280,000
In the quick ratio calculation, only items 1, 2, 5, 6, 7, and 8 are included. Remember, the quick ratio calculation only includes cash and cash equivalents which can be liquidated within 90 days.
The current ratio calculation will include the first eight items. The last item, the long-term building loan, is not included because it’s not due within the next 12 months.
The calculation for the current ratio would be:
Current assets: ($250,000 + $36,000 + $12,000 + $530,000 + $8,000) /
Current liabilities: ($3,000 + $17,000 + $24,000)
$836,000 / $44,000 = Current Ratio
19 = Current Ratio
The current ratio for your pharmacy is 19. This means you can pay the liabilities your pharmacy will owe in the next 12 months 19 times with your available current assets.
The Ideal Current Ratio
Being able to pay your short-term liabilities 19 times over with your available current assets might sound like an excellent current ratio. And there is something to be said for having a heavy cash position like this. If a disaster were to hit your business and you were out of commission for a few months, you would still be able to pay your obligations while you are getting back on your feet.
However, a very high current ratio can indicate missed opportunities to invest your business’s cash in order to grow your business.
The “ideal” current ratio is two, which indicates the business can pay its current liabilities with its current assets twice over. This doesn’t mean a higher current ratio is bad, but investors might have qualms about investing in a business that isn’t already effectively using its cash and cash reserves to further business growth.
A Low Current Ratio
As with the quick ratio, a current ratio of less than one can indicate a liquidity problem in your business. If your current ratio is less than one, it means that—as of the time of the calculation—you don’t have enough current assets on hand to cover the debts which you will owe within the next 12 months.
The key phrase here is “as of the time of the calculation.” Because your balance sheet is a snapshot of your business as of one specific date, your current ratio can change from one day to the next.
For example, if you just paid a big batch of vendor bills, but you haven’t yet received a large customer payment you know is on the way, your current ratio could be well below one. However, within a few days’ time, it could be above two again.
It’s important to monitor your current ratio over time. If it is consistently under one, then you could have a problem that needs to be addressed. If your current ratio is typically between 1.5 and two, though, having it drop for a short period of time probably isn’t cause for alarm.
How to Use the Current Ratio
Knowing your current ratio can allow you to quickly determine your business’s cash position and if you are incurring short-term liabilities too quickly. This makes the current ratio a powerful financial metric to use in the management of your business.
But as you might have guessed, lenders and investors also use the current ratio to decide whether to loan your business money or invest in it. Lenders want to know you will be able to repay the loan, with interest, and investors want a reasonable assurance they will receive dividends from their investment.
Current Ratio vs. Quick Ratio
During this discussion of the current ratio, you may be wondering how it differs from the quick ratio. While these two ratios are very similar, the key difference is that the quick ratio looks at cash and cash equivalents that can be converted to cash within 90 days. This means inventory, security deposits, and other less-liquid current assets are excluded from the quick ratio calculation because it typically takes longer than 90 days to fully liquidate these assets without deeply discounting them.
But inventory, security deposits, and other less-liquid assets are included in the current ratio calculation. The current ratio calculation takes into account all your business’s current assets, not just the ones that can be liquidated within the next 90 days.
The Bottom Line
The current ratio is a measure of your ability to pay your business’s short-term obligations. It’s a simple calculation that requires only one financial statement—the balance sheet—and it can be completed within seconds. But this one simple calculation can signal whether your business has a stable cash position or if you could be headed for trouble.
If you are concerned about your business’s current ratio, reach out to your accountant or bookkeeper. They will be able to help you understand your current ratio in light of your complete financial picture, giving you the peace of mind you need to confidently move your business forward.