There are many indicators that help investors and business owners to track the health of a business. Finance professionals look at cash flow, investments, and depreciation to see if an organization is growing wealth or losing money.
A common calculation you may come across in your company’s financials is the current ratio formula. This is used to parse out the assets from the cash on hand. Learn more about this formula and how it’s used in accounting.
What Is the Current Ratio Formula?
The current ratio goes by multiple names. It’s called the current asset ratio, the current liquidity ratio, and the working capital ratio. Whatever the label, this formula tries to answer the same question: how liquid is a business?
As a business owner, you have multiple types of assets. You have investments like your fleet vehicles, real estate, and equipment. You have inventory. You have accounts receivable (or money that is owed to your business). And you have cash in the bank—or liquid assets.
The current ratio formula evaluates all these components and compares them to your short-term liabilities (or costs) to see if your business can cover its debts.
Here is the current ratio formula:
- Current Ratio = Current Assets / Current Liabilities
For example, if a company has $10,000 in assets and $15,000 in liabilities, then its current ratio formula is 0.66.
If your current ratio is above 1, then your business has enough assets to cover your current liabilities. However, if your ratio falls below 1, then it would not be able to cover your costs and you may have liquidity problems.
Liquidity Changes by Company and Industry
While the current ratio formula is a useful gauge to determine how liquid most businesses are, it might not be useful in your particular situation.
For example, your company might have a significantly low current ratio if you receive payments quickly but take a while to pay suppliers and other creditors. Your ratio can also drop if you have low inventory levels or lack major assets as a remote organization.
Your current ratio will also change over time. The ratio will fluctuate if you make a major purchase, pay off debt, or simply adjust your inventory throughout the year. As long as you can explain why this ratio is changing and you’re in control of the changes, investors shouldn’t be too concerned.
Understand the Limits of a Current Ratio
While a current ratio is a useful guideline to understand the liquidity of a business, it isn’t necessarily specific. For example, 2 companies could have the same current ratios; however, 1 company could have its cash tied up in inventory and accounts receivable while the other has cash sitting in the bank.
If both companies needed to write a $20,000 check that day, the latter—with money in the bank—would be more qualified to do so. As you can see, it’s possible to have a high current ratio without a lot of cash on hand.
As a business owner, you have the power to adjust your current ratio—or simply to become more liquid. For example, if you have 90-day periods holding up your accounts payable department, you could have unpaid liabilities that aren’t getting addressed on time. If you have high inventory levels that take months to move, you are potentially hurting your current ratio.
If you plan to approach investors or lenders to buy into your business, then you may need to evaluate your current ratio and take steps to improve it. You want to prove to the best of your ability that your business is operating at its strongest and is worth investing in. While smart investors will look into the factors that contribute to this ratio, it doesn’t hurt to improve it when possible.
The Current Ratio Formula Is Deceptively Simple
The current liquidity ratio seems basic at face value: you have 2 numbers that you divide to get a percentage. However, this basic formula takes time. As a business owner, you still need to collect the data related to your assets and liabilities. You need to track your outstanding invoices and keep up with your inventory. If your bookkeeper isn’t organized, it can take several days to pull together this information—or worse, their numbers could be wrong.
The best way to pull basic accounting formulas is to keep your books updated and categorized. With this information, you can easily grab any numbers or insights you need and apply them to whatever financial or accounting formula you want. If you are still using a basic ledger or spreadsheet for your expenses, consider turning to another system.
At Sunrise, we offer free bookkeeping tools for small businesses. With our tools, you can auto-categorize expenses and label income accurately. This makes pulling reports like your P&L and balance sheet easy. Give our free services a try—and if you need something more advanced, turn to our professional bookkeepers for help.