How to calculate current ratio for your business

Business owners must create a list of key metrics used to manage a company, and that list should always include the current ratio. To work with the current ratio, you need to review each of the accounts in the balance sheet and consider how the current ratio can change.

Managers should also monitor liquidity and solvency, and there are three additional ratios that can help you get the job done.

What is the current ratio?

Wondering how to find your current ratio? Current assets that are divided by total current liabilities generate your current ratio, meaning it’s the ratio that determines if your business has sufficient current assets to pay current liabilities.

Financially sound companies have a current ratio of greater than one that they arrive at using a current ratio formula. If a company has $1.20 total current assets for every $1 of current liabilities, for example, the current ratio is 1.2.

To use the current ratio to make business decisions, you need to understand the balance sheet and the accounts that make up the balance sheet.

Reviewing the balance sheet accounts

A balance sheet is a picture of a company’s financial position at a specific date, and it reports the company’s assets, liabilities, and equity balances. It’s important to review this financial statement to track financial performance.

The balance sheet differs from an income statement, which reports revenue and expenses for a specific period of time. The cash flow statement reports the cash inflows and cash outflows for a month or year.

The balance sheet is based on the balance sheet formula: assets = liabilities + equity. Here are the components that make up a balance sheet:

• Assets: What your business owns. Assets are resources used to produce revenue.
• Liabilities: What your business owes to other parties. Liabilities include accounts payable and long-term debt.
• Equity: The difference between assets and current liabilities. You can think of equity as the true value of your business.

This list includes many of the common accounts in a business’s balance sheet.

Current assets (short-term assets)

A company’s current assets include cash and other assets that the company expects will be converted into cash within 12 months. Current assets are considered to be liquid assets.

• Cash: The total amount of money on hand (cash) and cash equivalents.
• Accounts receivable: The amount that your customers owe you after buying your goods or services on credit.
• Inventory: Items purchased for resale to customers.
• Prepaid expenses: Expenses you’ve paid in advance, such as six months of insurance premiums.
• Investments: Money-market account balances, stocks, and bonds (market securities). Some investments may be categorised as long term, but most are short-term investments.

Notes Receivable: Amounts you are owed that will be paid within 12 months.

Non-current assets (long-term assets)

• Fixed assets: Fixed assets include vehicles, equipment, and buildings used to produce revenue.
• Intangible assets: Assets that have no physical manifestation, such as goodwill, patents, copyrights, and trademarks, fall into this category.

Liabilities

Liabilities are amounts owed to third parties.

• Current liabilities: These are amounts due to be paid within a year, such as accounts payable (amounts you owe suppliers and employees), payroll liabilities, and amounts due on short-term business loans, such as a line of credit. Accountants also refer to this category as short-term obligations.
• Long-term liabilities: Amounts due to be paid in a year or more, such as long-term loans, mortgage payments, and future employee benefits. These liabilities are noncurrent, but the category is often defined as long-term in the balance sheet.

Equity

If you sold all of your company assets and used the proceeds to pay off all liabilities, any remaining cash would be considered your equity balance.

Equity may include:

• Capital stock: The dollar amount of common stock a company issues to shareholders. Issuing stock increases the equity balance.
• Net income: Total revenue less expenses, for a month or year. Net income is calculated in the income statement, and the balance increases equity.
• Retained earnings: Total company earnings (net income) since inception, less all dividends paid to owners since inception. Businesses can choose to retain earnings for use in the business or pay a portion of earnings as a dividend. Dividends reduce the equity balance.

Generating net income and issuing stock both increase the equity balance. If your business pays a dividend to owners or generates a net loss, equity is decreased.

Now that you’ve reviewed the balance sheet accounts in detail, you can start to think about the financial health of your business.

Understanding working capital, liquidity, and solvency

Business owners must focus on working capital, liquidity, and solvency so that their business can generate enough cash to operate.

Working capital is defined as total current assets less total current liabilities, and working capital reports the dollar amount of current assets greater than needed to pay current liabilities. Financially healthy companies maintain a positive balance of working capital.

Working capital is similar to the current ratio (current assets divided by current liabilities). Working capital is a dollar amount, and the current ratio is a ratio.

Liquidity is the ability to generate enough current assets to pay current liabilities, and owners use working capital to manage liquidity.

Businesses must also plan for solvency, which is the company’s ability to generate future cash inflows. Solvency is required to pay for capital expenditures, such as equipment, machinery, and other expensive assets needed to run the business. Liquidity and solvency should be monitored continually.

How to calculate current assets

To calculate the current ratio, refer to Outfield Sporting Goods’ 2022 balance sheet:

Download balance sheet on Excel

Outfield’s current assets include cash, accounts receivable, and inventory totalling $140,000. The $50,000 current liabilities balance includes accounts payable and the current portion of long-term debt. The current portion refers to principal and interest payments due within one year, and these payments are a form of short-term debt.

The current ratio is $140,000 divided by $50,000, or 2.8, meaning that Outfield has $2.80 in current assets for every $1 of current liabilities. Acceptable current ratios depend on industry averages, and a low current ratio can cause liquidity problems.

If current asset or current liability balances change, so too will the company’s current ratio.

Benefits and limitations of using current ratio

The current ratio is a great metric to monitor liquidity and solvency. If your current ratio balance is less than 1, you may have to borrow money or consider the sale of assets to raise cash.

Using the current ratio alone is not enough, however. To manage cash effectively, you need to monitor several other short-term liquidity ratios.

In most businesses, accounts receivable and inventory are large balances, and these accounts tie up your available cash. Successful cash management requires an owner to oversee accounts receivable balances, inventory purchases, and other metrics.

Three useful financial ratios for business decisions

Turnover ratios determine how quickly a business can produce an asset (or buy it into inventory), sell an asset, and collect the cash payment.

Accounts receivable turnover ratio: Collecting cash faster

Accounts receivable transactions are posted when you sell goods to customers on credit, and you need to monitor the receivable balance.

It’s a common business problem: your sales are growing, but you’re not collecting payments fast enough. Eventually, you may run short on cash. Monitor your accounts receivable turnover ratio to manage cash, using this ratio:

Net annual credit sales / average accounts receivable

Let’s define each component of the formula:

• Credit sales: Sales to customers who don’t pay immediately
• Net credit sales: Credit sales less any balances that cannot be collected
• Average accounts receivable: Beginning plus ending balance for a month or year, divided by two

A well-managed business can increase credit sales and keep their accounts receivable balance at a reasonable level. If you can increase the turnover ratio, you’ll collect cash at a faster rate, and the company’s liquidity will improve.

Inventory turnover ratio: Managing inventory levels

Inventory may be the largest dollar amount on the balance sheet, and a big use of your available cash. Your goal is to buy enough inventory to fill customer orders, but not so much that you deplete your bank account. If you have too much cash tied up in inventory, you may not have enough short-term liquidity to operate the business.

The inventory turnover ratio is the cost of goods sold divided by average inventory. The average is computed using the same formula as the accounts receivable turnover ratio above.

Your goal is to increase sales (which increases the cost of goods sold) and to minimise the investment in inventory. Assume that a firm generates $2,000,000 in sales, and that the average inventory balance is $200,000. The turnover ratio is 10 ($2,000,000 divided by $200,000).

If the business can produce the same $2,000,000 in sales with a $100,000 inventory investment, the ratio increases to 20.

Managers who take a measure of a company’s turnover ratios can increase liquidity, and produce a high current ratio.

Analysing the quick ratio (or acid test ratio)

The quick ratio formula is:

(current assets – inventory) / current liabilities

Outfield’s quick ratio is ($140,000 – $30,000) divided by $50,000 = 2.2. The quick ratio subtracts inventory based on the assumption that inventory will take the longest time to convert to cash.

Use the current ratio and the other ratios listed above to understand your business, and to make informed decisions. Some business owners use Excel for accounting, but you can increase productivity and make better decisions using automation.

Automate your accounting process

QuickBooks Online allows business owners to manage the entire accounting process online, and you can manage your inventory, input your bank statement, and generate financial statements using the cloud. Use QuickBooks Online to work more productively and to make more informed decisions.