As a business owner, it’s important to know if your business can pay its short-term and long-term obligations. To measure this, you can use the ratio most commonly used in the business world, the current ratio.
Why Is the Current Ratio Essential?
The current ratio shows your business’s ability to meet its current liabilities, or expenses, with its current assets, including cash on hand, open owed invoices, and stock. The reason this is so important is that a business can convert its current assets into cash within a year or less, and current liabilities are what a business owes within a year or less. This also paints a picture of your company’s cash flow. The higher the ratio, the stronger the position your company is in.
The Formula for the Current Ratio
The formula for the current ratio is: Current ratio = current assets / liabilities.
To illustrate, if a company has $500,000 in current assets and $250,000 in current liabilities, the equation expressing its current ratio is: $500,000 / $250,000 = 2.
Information Provided by the Current Ratio
The current ratio is an important measure for any business since it indicates a company’s financial health and helps predict cash flow over a period of time. A very low current ratio signals that your company may be experiencing financial troubles. A current ratio of less than 1 shows that liabilities due within the next 12 months are higher than your company’s current assets.
This can be a warning sign for investors, banks, or other financial institutions. While a low current ratio shows that a company’s financial health is on shaky ground, it doesn’t necessarily mean that you can’t recover. Likewise, a current ratio higher than 3 often indicates that your company isn’t utilizing its current assets to the best of its ability. If your score is too high or too low, you can use that information to make better informed decisions.
As a small business owner, you want to find the perfect balance between liabilities and assets to help your company flourish. Improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.