What is current ratio in business and how to calculate it?
The capacity to pay business bills is termed “liquidity.” To assess the growth of the business, investors and accountants primarily consider liquid assets and current assets.
Now, what is current ratio? The measurement of the liquidity of a business is called the current ratio.
Current ratio analysis shows the potential of a business to pay its short-term obligations by employing its current assets. The current ratio and working capital analyze the health of a business.
The current ratio, also known as working capital, highlights the capacity of businesses to pay bills on time. Current ratio analysis is important for a business to understand its financial standing in the market.
Understanding what is current ratio in business helps to understand the terms associated with it:
Current assets: Current assets are those assets possessed by a company that is expected to liquidate or convert into cash within a year. Inventory, cash and cash equivalents, accounts receivables, and prepaid expenses are a part of current assets.
Current liabilities: The obligations your business is required to pay within a year are termed current liabilities. It includes long-term debt to be paid within the upcoming 12 months, accrued expenses, and accounts payable.
We have understood what is current ratio, now it is important to know how to calculate current ratio in business. The current assets of a company divided by the current liabilities give you the current ratio. Businesses are required to understand the balance sheet to do current ratio analysis.
Balance sheets help you to get a clear picture of the financial health of your business. Current assets, also known as short-term assets, are changed to cash within a year.
1. Cash and cash equivalents: These include short-term securities and cash that can be quickly converted into liquidity. It includes money market funds, short-term government bonds, and treasury bills.
2. Marketable securities: These are purchased and sold on a public stock exchange and come with a maturity period of a year or less. It includes commercial paper, treasury bills, and common stock.
3. Accounts receivables: These include money to be received from customers for the products sold to them. It adds to the liquid assets and current assets of a business.
4. Inventory: It consists of unfinished parts, raw materials, and unsold stock.
5. Prepaid expenses: These are the expenses paid by a business in advance.
Another component of the balance sheet is current liabilities. It is also known as short-term debt or short-term obligations. It includes outstanding bill payments, accounts payable, deferred revenue, wages payable, and others.
To calculate current ratio, divide current assets by the current liabilities. Suppose the current assets of a company for a year are $ 252,000 and current liabilities are $ 42,000.
$ 252,000 / $ 42,000 = 6
This indicates that your business is capable of paying off the current liabilities six times over.
Suppose a company’s current assets are worth $ 150,000 and current liabilities are worth $ 10,000.
Current Ratio analysis = Current assets / Current liabilities
That means, $ 150,000 / $ 10,000 = 1.5
It implies that the current liabilities of the company can be paid one and half times employing the current assets.
In another example, if current assets are worth $ 2,750,000 and current liabilities are $ 3,000,000 the current ratio would be 0.92.
In this scenario, the company is likely to suffer a financial crisis because its current liability is more than its current assets.
To eliminate the risks associated with the financial crisis, companies need to add to their liquid assets and current assets.
Current assets more than current liabilities in the current ratio analysis are good unless the shareholders object to the hoarding of funds and payment of fewer dividends.
If the output of the current ratio analysis is greater than one, it is an ideal current ratio.
This shows that the company is capable of paying its current obligations on time without adding more debt. When the current ratio and working capital are positive, businesses don’t require fund infusion from investors and shareholders.
On the contrary, if the current ratio analysis produces an output of less than one, it shows that the business is not in a strong position to pay its current debts. The current ratio and working capital requirement vary from company to company.
It depends on the sector in which your business operates. If the current assets and liquid assets are consistently positive, it implies that the company is hoarding funds.
It is not investing business funds in the economy. If the current ratio analysis produces an outcome that is between 1.5 and 3, it is considered healthy for most businesses.
Current ratio analysis is essential, but it is not the only factor to be considered for the measurement of short-term liabilities. You have understood what the current ratio is; now let us know the limitations of the current ratio.
Quick Ratio: Quick ratio is just like the current ratio. However, inventory is not a constituent of the Quick ratio because it cannot be quickly converted into liquidity.
Quick ratio = (Current assets – Inventory) / Current liabilities)
Acid Test Ratio: Acid Test Ratio is a composition of the Quick ratio. The only exception is that it does not include inventory and prepaid expenses.
Cash Ratio: This method of current ratio analysis is the strictest. It does not include cash and cash equivalent.
Debt-to-Equity Ratio: When the total liabilities of a company are divided by the total shareholder equity, the Debt-to-Equity ratio is determined. By this, it can clearly understand what a company owes and what it possesses.
Therefore, current ratio analysis is not sufficient for knowing the financial health of a business. Businesses can analyze the liquid assets and current assets by using the above-mentioned metrics.
These metrics are capable of bringing clarity to your company’s financial position and market standing.
To sum up, current ratio analysis is necessary to find out the ability of a company to pay its short-term debts. It indicates a better picture of what a company owns and what it owes to its debtors.
Businesses need to understand what the current ratio is and what is included in a balance sheet. Next, they must understand how to calculate current ratio in business.
A current ratio in business and working capital less than one indicates poor financial health. On the other hand, a current ratio analysis that is more than one would mean that the business is not investing in new prospects.