Small Business Accounting Guide

14. The Current Ratio Formula

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Business Finance

The Current Ratio Formula

May 02, 2023 • 6 min read
Reviewing small business accounting
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      As a business owner, you should calculate financial metrics regularly to analyze your company’s financial performance and position. Otherwise, you might not have the insight necessary to make informed strategic decisions.

      The current ratio is one of the most commonly used financial metrics in financial planning. Here’s what you should know about it, including what it is, how to calculate it, and how to interpret your results.

      What is the current ratio formula?

      The current ratio is also commonly referred to as the working capital ratio. It’s a liquidity metric that compares your current assets to your current liabilities and primarily helps you assess how easily you can afford to pay off your short-term debts.

      The current ratio formula is as follows: 

      Current Ratio = Current Assets ÷ Current Liabilities

      Current assets refer to assets you can expect to convert to cash within one year. In addition to your existing cash reserves, that includes accounts like inventory and accounts receivable.

      Similarly, current liabilities refer to obligations due within one year, including upcoming portions of long-term debts. For example, short-term notes payable and accounts payable are both current liabilities.

      Here’s a demonstration of how you might have to calculate the current ratio formula in practice. Say your business has the following account balances:

      • Cash: $10,000
      • Inventory: $12,000
      • Accounts receivable: $8,000
      • Accounts payable: $10,000
      • Business credit card: $5,000

      Here’s what you’d get when you plug those numbers into the current ratio formula:

      $10,000 cash + $12,000 inventory + $8,000 accounts receivable = $30,000 current assets

      $10,000 accounts payable + $5,000 business credit card = $15,000 current liabilities$30,000 current assets ÷ $15,000 current liabilities = Current ratio of 2

      What is a good current ratio?

      Good current ratios are always at least above 1. That means your current assets exceed your current liabilities and you have enough resources to fulfill your upcoming obligations. Business owners often aim for a ratio of 1.5 to give themselves a buffer.

      However, you don’t want your current ratio to be too high. If it’s above 3, you can afford to pay off your short-term debts more than three times over. That means your business is safe from liquidity issues, but you may not be leveraging your assets efficiently. For example, an inflated current ratio could indicate you have more cash than necessary. You may want to invest your excess funds into projects that would grow your business, such as expanding your marketing efforts or sales team.

      Current ratio vs. quick ratio.

      The current and quick ratios are liquidity metrics that compare your company’s current assets to its current liabilities. However, the quick ratio excludes your business’s inventory from the calculation.

      Here’s the formula for the quick ratio: 

      Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities

      Whether you incorporate the current or the quick ratio into your financial analysis depends primarily on your business model and the time horizon over which you’re trying to investigate your company’s liquidity.

      For example, say your business turns its inventory over every 180 days, and you want to assess your ability to meet your obligations this month. You should probably use the quick ratio since you won’t be able to liquidate much of your inventory in 30 days.

      Liquidity changes by company and industry.

      A liquidity ratio below 1 is always concerning, since it indicates your current liabilities exceed your current assets, and you might struggle to fulfill your obligations. However, beyond that, the ideal current ratio can vary depending on the nature of your business.

      For example, some industries and business models (Ex: retail and grocery stores) require higher levels of inventory, which can inflate the metric.

      Conversely, software-as-a-service (SaaS) companies tend to have lower current ratios. Not only do they not have a physical inventory, but they also tend to collect payment up front and lack accounts receivable.

      Ultimately, you must consider your company’s unique circumstances to determine whether your liquidity ratios are healthy. Consider reviewing your industry’s average results to help set your expectations.

      Understand the limits of a current ratio.

      The current ratio helps analyze the liquidity of your business, but it can only tell you so much on its own. You must investigate the numbers behind your current ratio and think critically to gain meaningful insights.

      For example, two companies can have the same current ratios, but one might be flush with cash while the other has its working capital tied up in inventory and accounts receivable. These are two significantly different financial positions.

      If both companies have significant liabilities due at the end of the month, the one with cash reserves could easily afford to pay them. However, the other might struggle to liquidate its assets in time.

      As a result, you must remember that the current ratio is only one lens into the health of your business’s financial position. Always supplement it with deeper financial analysis to better inform your decisions.

      The current ratio formula is deceptively simple.

      The current ratio formula is easy to calculate once you have all the necessary pieces. However, keeping track of your assets and liabilities can be challenging, especially if you have a sophisticated inventory.

      The more moving parts your business has, the more beneficial it is to invest in accounting software that can track your activities automatically. You may also want to consider hiring a bookkeeper to help ensure your financial records are accurate.

      If you can’t afford a full-time employee, you can outsource your bookkeeping to an independent contractor or bookkeeping firm. When it’s time to perform financial analysis, it’ll be much easier since you’ll already have accurate financial statements.

      About the author
      Nick Gallo, CPA

      Nick Gallo is a Certified Public Accountant and content marketer for the financial industry. He has been an auditor of international companies and a tax strategist for real estate investors. He now writes articles on personal and corporate finance, accounting and tax matters, and entrepreneurship.

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