Does your business have a steady financial standing, or do you need help to make ends meet? Knowing the answer to this question is of utmost importance as it could mean the difference between success and failure. A critical measure that can give you an indication of your financial health is the current ratio.
You can easily measure a company’s ability to meet short-term obligations through the current ratio. With some understanding of how to use it, you can gain insight into your organization’s financial situation, helping you make better decisions for future growth and stability.
Key Takeaways
- Understand your business’s current ratio to gain insight into the resources available to fund investments or expansions. Knowing the current ratio helps companies make better decisions, which can lead to long-term success.
- Having a very high current ratio can be a sign of inefficiency. Companies may not be using money wisely to maximize revenue and profitability, and they may experience liquidity risk if the value of their assets decreases or they cannot quickly convert them into cash.
What is the Current Ratio?
The current ratio is a financial measure used to assess a company’s short-term financial health. The current ratio measures whether or not a company can meet its short-term obligations and can help you understand the financial health of your business.
Knowing your business’s current ratio will allow you to avoid any potential liquidity problems, which could arise as debt or other liabilities become due.
Additionally, understanding your company’s current ratio also grants insight into the resources available to you to fund any future investments or expansion plans you may have for your business.
Ultimately, keeping track of the current ratio allows companies to make better decisions to set themselves up for long-term success.
Current Assets
Your company’s current assets, also called short-term debt, can quickly be converted into cash within 12 months. Money makes up most of the current assets, but other forms like cash equivalents, stocks, inventory, accounts receivable, and prepaid expenses can also count as current assets.
These help companies maintain liquidity, allowing them to pay their bills on time when they become due without needing external assistance.
The company’s current assets include cash and equivalents such as marketable securities, raw materials, and finished goods in inventory, accounts receivables from customers, prepaid insurance, and other prepaid taxes or expenses – as you can find all the details from the balance sheet.
Current Liabilities
Current liabilities are obligations you must pay within one year or less, including premium payments, rent, payroll taxes, loan repayments, and credit card debt in the company’s balance sheet. They can also include accrued expenses such as unpaid bills, wages, or dividends payable.
Businesses need to understand their liabilities to keep them manageable over time and prevent future surprises that could derail their operations.
Formula for the Current Ratio
The current ratio formula is relatively simple to calculate. Business owners often use it to know how much liquidity their company has and if it can meet its short-term obligations. The formula itself is simply current assets divided by current liabilities.
How to Calculate? – Current Ratio Example
To calculate the current ratio, businesses must look at their balance sheet from a recent financial period. For example, if you were looking at Microsoft’s balance sheet from 2022, you would find two critical pieces of data: total current assets and current liabilities for current ratio calculator:
Microsoft’s Annual Report 2022: Current Assets
| Cash and cash equivalents | $13,931 |
| Short-term investments | $90,826 |
| Accounts receivable | $44,261 |
| Inventories: | $3,742 |
| Other current assets | $16,924 |
| Total current assets | $169,684 |
Microsoft’s Annual Report 2022: Current Liabilities
| Accounts payable | $19,000 |
| Current portion of long-term debt | $2,749 |
| Accrued compensation | $10,661 |
| Short-term income taxes | $4,067 |
| Short-term unearned revenue | $45,538 |
| Other current liabilities | $13,067 |
| Total current liabilities | $95,082 |
- Accounts payable: 19,000
- Current portion of long-term debt: 2,749
- Accrued compensation: 10,661
- Short-term income taxes: 4,067
- Short-term unearned revenue: 45,538
- Other current liabilities: 13,067
- Total current liabilities: 95,082
You can then calculate the Current Ratio by dividing total current assets by total current liabilities. For example, if Microsoft had $169.684 million in current assets and $95.082 million in current liabilities, their Current Ratio would be 1.78 ($169.684 / $95.082 million).
The result means that for every $1 of debt, they have $1.78 in assets available to pay it off – providing a good buffer against any unexpected losses or events.
What Is a Good Current Ratio?
An excellent current ratio for most businesses is generally considered 1.5 or higher, meaning the company has 50% more assets than liabilities.
The current ratio below 1 or the industry average can signify a potential liquidity crisis. This number means the company will need more funds to meet its obligations and could struggle with paying essential expenses like payroll and inventory costs.
However, if the current ratio is too high, it can show inefficiency. Companies with large amounts of liquid assets may not efficiently use the money or invest it wisely to increase revenue and profitability.
These companies may also face liquidity risk if their assets’ value diminishes or they cannot quickly turn the assets into cash.
5 Solutions to Overcome a Low Current Ratio
#1: Increase liquidity through asset sales
Asset sales could include selling property, inventory, or other business assets they no longer need. Doing so can provide you with more cash to help meet their short-term obligations and improve your current ratio.
#2: Decrease debt
You can renegotiate loan terms with creditors, consolidate debt into one loan, or refinance high-interest loans. These actions will free up capital which you can then use to pay off other loans and improve a business’s current ratio.
#3: Improve the accounts receivable collections process
This solution includes ensuring that you send invoices promptly, following up promptly when payments are late, and enforcing payment deadlines by charging late fees or offering discounts for early payments.
By doing this, businesses will get paid more quickly and have more cash available, which you can use to pay off outstanding debts and improve the Current Ratio.
#4: Take advantage of merchant cash advances or accounts payable financing
Merchant cash advances are typically offered as loans against future credit card sales, allowing businesses to get the funding they need without taking on additional debt.
Accounts payable financing will enable companies to receive an advance against existing invoices from customers, providing them with much-needed capital without risking defaulting on their loans or depleting their resources.
#5: Cut costs or expand into new markets
This could include cutting costs such as reducing staff size or operational expenses and expanding into new markets where demand is higher than in current needs.
Doing so would enable them to bring in more revenue while keeping costs at a minimum and ultimately help improve your current ratio overall.
Some Limitations of the Current Ratio
A current ratio is valuable for measuring a company’s short-term liquidity. Still, it also has a few limitations that should be considered when interpreting the results.
#1: Limited Scope
The current ratio only looks at a business’s current assets and liabilities, so it does not indicate its long-term performance. It can also take advantage of potential sources of income, such as investments or equity, which you could use to meet liabilities if needed.
#2: Timing Issues
The current ratio can be affected by timing issues. For example, if customers receive cash before the end period, it will be included in current assets. Still, any payments to suppliers from that period may have yet to be made and would not affect the ratio. This can lead to an inaccurate calculation of liquidity.
#3: Inability to Measure Efficiency
The current ratio fails to measure efficiency because it needs to consider how quickly current assets are converted into cash or how quickly current liabilities are paid off. As such, companies can have high liquidity levels while still being inefficient with their financial management practices.
Current Ratio vs. Quick Ratio vs. Other Liquidity Ratios
| Formula | Purpose | Interpretation | |
| Current Ratio | Total Current Assets / Total Current Liabilities | Measure the overall liquidity of a business | A ratio above one indicates that the company has the resources to meet its short-term liabilities. |
| Quick Ratio | (Total Current Assets – Inventory) / Total Current Liabilities | Measure the company’s ability to pay off short-term liabilities without having to rely on inventory sales | Higher ratios are generally better; it shows that a company can meet its short-term obligations even if there is an unexpected drop in sales. |
| Cash Ratio | (Cash+Marketable Securities) / Total Current Liabilities | Measure the company’s ability to pay off short-term liabilities with highly liquid assets | Higher ratios are generally better; it shows that a company can meet its short-term obligations even if there is an unexpected drop in sales. |
| Acid Test Ratio | (Cash+Marketable Securities + Accounts Receivables) / Total Current Liabilities | Measure the company’s ability to pay off short-term liabilities with all short-term financial resources | A high ratio shows that the company can meet its short-term obligations even if an unexpected drop in sales or accounts receivable collection times increase. |
| Asset Turnover Ratio | Sales / Average Assets | Measure how efficiently business uses its assets to generate revenue. | Higher ratios are generally better; they show that a business uses its assets effectively to generate sales. |
Maintaining Healthy Finances with Professional Accounting Firm
Professional accountants are experienced in spotting areas of improvement and understanding the complex complexities involved in financial decision-making:
- Monitor your bank accounts regularly and check credit reports annually.
- Save money by cutting unnecessary expenses and shopping for competitive rates on products or services you need.
- Consider automated savings plans or investments that fit within your budget.
- Pay off debts as soon as possible to avoid high-interest rates or late fees.
- Develop an emergency fund in case of unexpected expenses or job loss.
A good accounting firm can provide insight into sound financial decisions and help manage your finances more effectively and efficiently. With the right resources, you can enjoy fast economic growth today and in the future. Contact us today for FREE CONSULTATION.
