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Business Financials – What is Current Ratio formula / meaning & what does it show us?

images/Business Financials.JPGThere are many financial ratios that can be used to analyse business financial, and a common one is current ratio formula which shows the proportion or amount of current assets to current liabilities.

The current ratio is also known an indicator of a company's liquidity.

Put in another way, if there is a large amount of current assets in relationship to a small amount of current liabilities there is some assurance that the obligations coming due will be paid.

“Current” refers to amounts available or due within 12 months, such as cash, inventory and credit cards, money debtors owe you and supplier creditors who you need to pay, unlike equipment assets that are help over several years, and finance and loans to be paid over several years, which come under Long-term categories.

If a company has –

Example 1

current assets are $500,000

current liabilities are $250,000

current ratio is 2:1   (500/250 = 2).

Assets are 2x Liabilities

Example 2

current assets are $600,000

current liabilities are $500,000

current ratio is 1.2 : 1    (600/500 = 1.2)

Assets are 1.2x Liabilities

Clearly a larger current ratio is better than a smaller ratio in comparison to current liability.

Generally, a current ratio that is less than 1:1 indicates insolvency, and the preference is at least 2:1, or over 2.

When benchmarking a company, or comparing your own, it is wise to compare a company's current ratio to those in the same industry. It is also worth keeping a close look at the trend of the current ratio for a given company over time.

Is the current ratio improving over time, or is it deteriorating?
Also, the composition of the current assets is also an important factor. If the current assets are predominantly in cash, marketable securities, and accounts receivable, that is more valuable than having the majority of the current assets in slow-moving inventory.

Need help? Not sure? Call for FREE 30min advice / strategy session today!

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