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The current ratio calculates a company’s financial health. Bankrate explains.
What is the current ratio?
The current ratio is a comparison of a company’s current assets to current liabilities that can be used to find its liquidity, usually as a comparison between companies in the same industry. Potential creditors use the current ratio to measure a company’s ability to pay off short-term debt.
It’s easy to calculate the current ratio. Just divide Current Assets by Current Liabilities. That equation includes cash, accounts receivable, and inventory.
However, it’s not so easy to determine what it means for a given company’s financial health. That’s because it’s only really useful in comparing businesses in the same industry and only produces a rough estimate. There’s also the fact that high and low ratios mean different things for different creditors. To one creditor, a high ratio may mean the company has a lot of liquidity, meaning the creditor would be more willing to extend a loan. But too high a ratio may also mean that the company is inefficiently using its assets to generate growth.
As opposed to the quick ratio, the current ratio includes all assets, including those among the company’s inventory that are more difficult to convert to liquidity in that fiscal year. That makes it less specific than other ratios that also measure liquidity.
Are your liabilities exceeding your assets? Check out if refinancing is right for you.
Current ratio example
Katie wants to get a business loan to expand her pet supply store. According to Katie’s business balance sheet, she has $150,000 in current assets. They include items like the small building where her shop is located, her current inventory, office equipment and bank accounts associated with the store. She also has about $75,000 in current liabilities. These include items like wages owed to her three employees and accounts payable. So, to determine her current ratio, the bank used the formula
$150,000/$75,000 = 2
Katie’s current ratio is 2, which is considered a healthy business in many industries. The bank approved the loan.
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