Current ratio is a measure to gain insight into the liquidity of the company. The purpose of this liquidity ratio is to determine whether current financial obligations can be met in the short term. It concerns the ratio between current assets plus cash and short-term liabilities.
The formula for calculating the current ratio is:
Current assets + cash / short-term liabilities
Explanation of terms in calculating current ratio
The current ratio is easy to calculate with the company balance sheet, where the different values are listed. It is useful to know what is meant by current assets, cash, and short-term liabilities. For example, current assets include inventory with products and debtors with outstanding invoices. Cash includes money that is physically in the cash register, but also money in the bank. Short-term liabilities include debts to the bank, but also fixed costs such as rent, outstanding bills to suppliers, and taxes that still need to be paid.
Insight into the company’s liquidity
Calculating the current ratio reflects a company’s liquidity. The company balance sheet forms the basis for the calculation. It is important to know that the result can vary daily. If there is a deposit, it changes the outcome of the current ratio. To gain a clear insight into the company’s liquidity, it is advisable to calculate the current ratio multiple times over a period.
Why calculate the current ratio?
It is important in various situations to know what a company’s current ratio is. An investor, for example, wants insight into a company’s financial situation and to determine whether the company can meet its financial obligations in the short term. The current ratio provides insight and can give investors and other lenders more certainty in that regard. Moreover, the current ratio can be improved by optimizing debtor management and focusing on effective cash flow management.
In that case, you get real-time insight into the available resources. Moreover, effective cash flow management is not only ideal in the short term but also for determining the strategy for the future. The current ratio can be optimized with debtor management by shortening the payment term for debtors and by paying attention to the follow-up of invoices. With Payt, it is also possible to automatically follow up on invoices. It is also possible to consider selling unsuccessful inventory. To adjust the current ratio, it is of course important to know when it is good or not.
When is the current ratio good?
The current ratio is good when the result of the calculation is above one. If the result is below one, it means that the financial resources and/or inventory are worth less than the debts. In this example, the short-term debts are higher than the current assets, which suggests that the company may not be able to meet all financial obligations in the short term. Generally, 1.5 is the norm for a good current ratio, but a result of 1.8 is better. However, it is always possible that a financial setback occurs or that it is not possible to fully convert the inventory into cash. You may also encounter debtors who pay late or not at all, resulting in a lower current ratio.
It is important to know that the current ratio should be viewed in the context of the relevant sector. Therefore, it is preferable to compare the result with the current ratio of companies in the same industry. Moreover, a result below one does show a risk, but it does not mean that the company will immediately go bankrupt. In that respect, there are other options to obtain capital for the company. Furthermore, a current ratio of two is not always considered favorable. It shows that there are many current assets within the company or that there are many outstanding receivables and it is difficult to collect the money from debtors. Of course, it is good to know that calculating the current ratio is just a snapshot and is subject to change.