Periodically we will highlight a ratio or benchmark and demonstrate how you can use it to better understand your business
The disclaimer: Benchmarks and ratios, blindly applied, can be dangerous. Benchmarks can be useful in understanding areas to investigate, but it’s important to understand what’s being compared and why variances might exist.
The Ratio: Current Ratio
The current ratio is one of many financial ratios used by business analysts to assess the health of a business. The current ratio is calculated by taking a business’s total current assets (cash, accounts receivable, inventory, etc.) and dividing that by a business’s total current liabilities (accounts payable, accrued expenses, current portion of long-term debt, etc.). For example, if Calvin’s Clam Bar has $100,000 in current assets and $50,000 in current liabilities, then its current ratio is 2:1.
The current ratio is a basic measure of a business’s solvency that is often used by business managers, investors, and lenders. Business managers often use the current ratio to monitor a business’s ability to pay its current liabilities from month to month. For example, if a manager notices that sales are slowing down, he/she may want to decrease vendor purchases. Likewise, if a manager notices an increase in business, he/she may want to increase vendor purchases. By using the current ratio, business managers can make smart purchasing decisions that will allow him/her to manage the current liabilities balance to ensure that a current ratio of 1:1 or above is maintained. Investors often use this ratio to assess the solvency of a business as well as management’s ability to manage the flow of a business while making purchase decisions. Lastly, lenders will use the current ratio to determine whether or not a business is capable of taking on a loan and still able to pay its current liabilities.
Acceptable current ratios vary from industry to industry but are usually between 1.5:1 and 3:1 for healthy businesses. In general, a business should at least maintain a 1:1 current ratio. Any business with a current ratio below 1:1 is most likely considered insolvent.
However, when reviewing current ratios it is important to look at the full picture of the business. For example, Calvin’s Clam Bar has a current ratio of 5:1 with total cash in excess of current liabilities of $150,000. Although the current ratio shows the business is financially stable, this may indicate that the manager of Calvin’s Clam Bar is using current assets inefficiently. The excess cash could be used in other parts of the business to encourage growth and expansion. Therefore a high current ratio does not always mean a business is operating effectively.
Furthermore, a current ratio below 1:1 does not always mean a business is insolvent. For example, Calvin’s Clam Bar has a current ratio of .75:1 with total cash in excess of current liabilities of $15,000 due to the manager’s ability to keep inventory levels low with a quick turnover rate. The manager’s ability to turn over inventory quicker than accounts payable become due allows Calvin’s Clam Bar to operate with a current ratio below 1:1 and still be financially stable.