No matter how quickly your business is evolving, it can soon take a hit if short-term debts are a matter of concern. In that case, you may need to uncover your company’s capabilities in order to meet the financial obligations.
The current ratio plays a significant role in comparing the current assets to the current liabilities, helping you identify whether the company can cover the short-term debts.
Importantly, the current ratio also draws investors as they would be pretty much interested in comparing your company with its competitors and assessing your ability to meet short-term debts. Therefore, it’s no wonder why you need to maintain the ideal current ratio.
Of course, we will throw light on what’s good or bad current ratio, and how to calculate the current ratio. But, first, let us move on to understand what is current ratio definition.
What Is the Current Ratio?
The current ratio is a process of assessing whether the company is capable of paying short-term debts. Sometimes known as working capital, the current ratio compares the company’s assets and liabilities in a way that ensures a sustainable financial balance.
The higher the current ratio, the greater the capability to cover its dues. However, a low ratio indicates liquidity challenges. The current ratio is one of the first things your investors or stakeholders notice on the balance sheet as it outlines the company’s ability to settle their debts.
How Does the Current Ratio Work?
The current ratio analyzes the current assets (inventory) and matches with current liabilities (short-term debts) to gauge whether the company is really capable of performing its financial obligations.
There isn’t any complex formula for finding the current ratio, because all you need to do is divide the current assets with the current liabilities. If the current ratio is > 1, it signifies a solid liquidity position, which means the company can easily cover its short-term obligations without straining the budget.
If the scenario is reversed, a ratio < 1 points towards potential liquidity challenges, which means the company may struggle to meet its financial obligations. It’s difficult to say what’s the perfect ratio because it can vary according to your industry.
Ideally, it’s important to maintain a balanced ratio because investors and lenders will assess it before making any investment. The current ratio provides a broader and clearer picture of the company’s financial landscape.
Now that you know the current ratio meaning, let us find out how to calculate the current ratio.
How to Calculate Current Ratio
Calculating the current ratio starts with obtaining the information from the balance sheet. So, firstly, get a snapshot of your company’s assets and liabilities. Look for receivables, inventory, or cash to sum up current assets.
Thereafter, compile a list of the current liabilities such as accrued expenses or any short-term debt. Once you have all the data in hand, populate it in the below-given current ratio formula.
Current Ratio Formula
Current Ratio = Current Assets / Current Liabilities
The resulting number you get is what will be considered the current ratio, which further identifies if your company is capable of covering debt expenses.
Set Yourself Free From Manual Calculations
Switch to Moon Invoice where automation does all the hard work 🏋️for you to generate accurate financial reports.
Example of Current Ratio
For example, let’s say you have gathered all current assets and liabilities. The cash is $80,000 and the inventory is $100,000, bringing the total assets to $180,000. Meanwhile, $45,000 in accounts payable and $20,000 in short-term debt collectively contribute to the total liabilities of $65,000.
Next, use the current ratio formula:
$180,000 [Current Assets] / $65,000 [Current Liabilities]= 2.76 [Current Ratio]
Here, the current ratio falls to 2.76, which means the company has $2.76 for every dollar of liabilities, suggesting a strong liquidity position. This means the company is capable of covering its debts. Anything above 2 indicates the company has twice the assets required to meet short-term liabilities.
What are the Challenges of the Current Ratio?
Here are some current ratio limitations you might want to know before jumping into what’s good or bad current ratio.
1. Valuation of Inventory
Since inventory is a vital component of current assets, its valuation can pose several challenges. This is because they utilize accounting methods like FIFO (First-In-First-Out) or LIFO (Last-In-First-Out), which are likely to impact the valuation of inventory, eventually lowering the current ratio.
2. Account Receivables Qualities
The company’s account receivables are not always collected on time. Some receivables are overdue or may become bad debts, impacting the liquidity position and resulting in a weaker current ratio. If your company includes longer payment terms, receivables may take more time to convert into cash.
3. Unexpected Fluctuations
The current ratio may fluctuate for seasonal businesses at any time during the year. Sometimes, the current ratio is high because of increased account receivables and inventory. Whereas, the current ratio is low due to a rise in short-term liabilities. Therefore, it is challenging to determine the accurate picture of a business’s financial health from the current ratio.
4. Accounting Gimmicks
Companies in several industries have already normalized accounting gimmicks in a bid to make their current ratio stronger. They may deliberately take longer than usual to clear short-term liabilities and pay only after the reporting period to raise the current ratio. Such tricks can mislead investors and creditors by displaying an inaccurate financial picture of the company.
What is a Good & Bad Current Ratio?
The current ratio can significantly differ according to the various industries, ideally anything between 1.0 and 2.0 is defined as a good current ratio. It symbolizes that the company has adequate assets to pay its debts. In case the ratio is 2.0 or more, the company owns twice the assets needed to fulfill the short-term obligations, which are typically due within one year.
Negatively, if the current ratio dips below 1.0, it is considered a bad ratio. Obviously, because it unveils that liabilities are more than the current assets. A bad current ratio demonstrates that the company is likely to struggle to cover its short-term obligations.
What are Other Useful Ratios?
Apart from the current ratio, below are some other useful ratios offering a clear idea of the company’s assets and liabilities to investors. With these ratios, they can even know how financial statements are changing over a specific period.
1. Quick Ratio
A quick or acid-test ratio is crucial for gauging a company’s liquidity without considering inventory. It only accounts for liquid assets such as cash, receivables, and financial securities.
2. Cash Ratio
Similar to a quick ratio, the cash ratio also measures liquidity but in a stiffer way i.e. considering cash and its equivalents. It factors out accounts receivable, focusing only on immediately available funds.
3. Debt-to-equity Ratio
The Debt-to-Equity Ratio measures solvency to determine how much the company depends on the leverages (borrowed funds) in comparison to equity. A higher ratio alludes to increased financial risks.
Secure Investments with Data-Driven Financial Reports
Let Moon Invoice create accurate financial reports that speak for you and attract investors with clear insights
The Current Ratio in a Nutshell
The current ratio is a liquidity ratio, often used to measure solvency and to generate an investor-worthy report so that investors can get insights into a company’s financial health. Simply put, the current ratio above 1 or less than 2 is typically a good ratio, and the ratio below 1 is considered a bad ratio. However, the same can’t be said for some industries where seasonal fluctuations often weaken the current ratio.
Since now you know how the current ratio works and how to calculate it, what you need is reliable invoicing software. Software like Moon Invoice, where you can store financial documents and track accounts receivable and accounts payable to create high-quality reports in less than a minute. Switch to Moon Invoice by starting your 7-day free trial.
FAQs
Jayanti Katariya is the founder & CEO of Moon Invoice, with over a decade of experience in developing SaaS products and the fintech industry. He holds a degree in engineering. Since 2011, Jayanti's expertise has helped thousands of businesses, from small startups to large enterprises, streamline invoicing, estimation, and accounting operations. His vision is to deliver top-tier financial solutions globally, ensuring efficient financial management for all business owners.
