Everything That You Need to Know About Current Ratio
In any business, you should be keeping an eye on your bottom line. Your profitability is essential to funding the operation. You should always perform financial forecasting to make sure you have enough capital to cover your costs over the coming fiscal year. One way to measure your financial performance is through the current ratio. But what exactly is the current ratio, and what is considered a good current ratio? If this is something that you want to learn more about, read on as we break down everything you need to know about the current ratio.
What Is the Current Ratio?
The current ratio is one of several liquidity ratios that businesses can use to evaluate their ability to pay short-term obligations. A short-term obligation is defined as something that is due to be repaid within one year. Short-term bank loans, accounts payable, lease payments, or wages are all considered short-term obligations, as is the current ratio. The current ratio measures whether the business’s current assets are enough to cover its current liabilities. This can also be referred to as the working capital ratio.
A higher current ratio indicates better short-term financial health. A 1-1 ratio indicates a company has enough current assets to cover its short-term liabilities without having to liquidate any fixed assets. Any ratio under 1 indicates the company is not able to cover its liabilities.
How Does the Current Ratio Work?
Current ratios are used to compare the current (quick) assets of a company to its current liabilities. Quick assets are assets that are readily convertible to cash, such as cash itself, or accounts receivable. Ratios can be used to determine whether a company can meet its obligations without having to sell its fixed assets or raise additional capital.
What Is the Current Ratio Formula?
If you want to calculate the current ratio of a company, you take the company's current assets and divide them by its current liabilities. The current ratio is a relatively simple formula that requires two measurements from a company's balance sheet to make it work.
The current ratio formula is:
Current Ratio=Current AssetsCurrent Liabilities
What Is a Good Current Ratio?
Many industries have no set rule for the "right" current ratio; it really depends on what works best for each company. The current ratio of a company is a constantly changing and evolving figure, often modified in order to address the needs of the business. This is due to ongoing payments to liabilities, various assets being liquidated, and sales and other sources of revenue. When setting a target for the current ratio, many companies pick a range that works best for that organization.
Sometimes, a company's ratio between its assets and liabilities is a good indicator of its financial health. In general, investors and business owners consider a ratio between 1.2-to-1 and 2-to-1 to be a sign of a healthy company, which means that the company has the ability to meet short-term liabilities while also being able to invest a healthy percentage of its capital. If a business has a ratio that’s higher than 2-to-1, it may suggest that the company is not investing its short-term assets effectively. On the other hand, if the ratio is lower than 1-to-1, it may signal that the company is having financial difficulty; however, this is an easier problem to fix than if the ratio is higher than 2-to-1.
Conclusion
We hope this article proves to be useful when it comes to furthering your understanding of the current ratio. The current ratio is a financial benchmark that business owners should consider when they are analyzing their financial performance. Be sure to keep everything that you learned here in mind so you can tell if your business is in a good position.
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