Accounting ratios can be a great method of measuring business efficiency. They very concisely convey what hefty balance sheets and profit and loss statements do.
The current ratio is a widely used working capital ratio that is used by businesses to keep their liquidity within favorable limits. In this article, you'll know what a healthy current ratio looks like and how to calculate it for your business.
The current ratio is one of the two working capital ratios which are widely used to gauge a firm's liquidity. Liquidity refers to the ability of a firm to convert its assets into cash before current liabilities are due.
Assets presented in the balance sheet follow an order of liquidity, i.e., the most liquid assets (usually cash) are presented as the first sub-item under the Current Assets head
Liquidity is one of the key areas which a company has to constantly monitor. This is because liquidity reflects the firm's ability to pay on time, which is something that suppliers and vendors of a firm are the most concerned about.
For instance, Firm A orders a set of supplies from its vendor Firm B on the condition by Firm B that Firm A will settle the payment within the next 30 days. However, Firm A is not able to fulfill this condition.
This might prompt Firm B to take a stricter stand and reduce the credit period, demand a penalty (as per the clause of the agreement), or straightaway refuse to ship supplies to Firm A on credit.
So, liquidity is an important aspect as far as the working of Firm A is concerned. Businesses usually work on credit because they pay their suppliers in full or partially when they have received payments from their own customers.
Suppose Firm A scores a large order but will only be paid once it is fulfilled. With Firm B demanding cash payment before shipping, Firm A has no choice but to pay, which leaves them with less cash for other contingencies.
In some cases, bank loan agreements contain clauses stating that the firm has to maintain a particular level of current ratio, which is affected as liquidity dwindles. Also, a firm with ample liquidity might be able to avail benefits like discounts on cash down payments.
The current ratio is a simple calculation that requires the business to divide its current assets by current liabilities. The formula is:
Current Ratio = Current Assets/Current Liabilities
Current assets constitute everything that your business can sell and convert into cash within a year. Other than cash, some investments (like the stock market), accounts receivable, and inventory are considered current assets.
Heavier investments like building, machinery, and equipment do not fall under the ambit of current assets since they might take a little more time to sell.
Current liabilities include accounts payable, payroll, income tax payable, sales tax payable, interest payable - virtually every payment that falls due within a year.
So, for instance, your business's assets and liabilities are:
The current ratio of your business would be calculated as follows:
Current Assets = (10,000 + 50,000 + 30,000 + 20,000) = $110,000
Current Liabilities = (40,000 + 10,500 + 5000) = $55,500
Current Ratio = 110,000/55,500 = 1.981
Thus, for every dollar worth of current liabilities, your business has almost twice the amount to be able to pay.
The current ratio demonstrates your firm's ability to pay its dues on time. A high current ratio might be something that will improve your company's standing amongst its vendors or suppliers - or even put a smile on the loan manager's face.
But that doesn't generally mean that your company must aim for the stars when it comes to the current ratio!
A healthy range for the current ratio lies between 1 and 2 (the lower bound is definitely 1). However, it is subjective to the nature of business and the flow of cash.
Having a current ratio above 1 indicates a pretty healthy financial position for your company. It signifies that your business would be able to pay off all its current debts in full.
Having a current ratio exceeding 1.5 is an even more reassuring instance. But it should not jump to a very large number because a huge current ratio implies idle cash or liquidity lying around the firm.
You could put these idle liquid funds to use as investments for earning interest. Alternatively, you can turn them into long-term investments for growth, such as equipment and machinery for the expansion of your firm.
Like the current ratio, there are a ton of other financial ratios that companies can calculate to better judge their financial health.
These ratios are the first things investors or creditors often look at since they summarize a company's fundamental position with respect to debt, liquidity, operating capacity, and efficiency - not to mention profits.
Let's delve into some of the important ratios your company must pay close attention to:
The debt-to-equity ratio is perhaps the most popular ratio when it comes to the debt structure of a particular firm. It is also known as "risk ratio" or "gearing" and indicates which direction your company's funding is inclined towards.
This ratio takes debt as the numerator and shareholders' equity as the denominator. A ratio below 0 signifies the predominance of equity in the company's funding, whereas a ratio of 1 or above is indicative of a highly leveraged firm.
The formula for the debt-to-equity ratio is:
(Short-Term Debt + Long-Term Debt + Other Fixed Payments)/Shareholders' Equity
The Net Profit Margin belongs to the family of financial ratios that measure the profitability of a company.
It essentially calculates the total profit a company generates from its sales and revenue or the amount of net profit it earns per dollar of revenue earned.
Net Profit Margin = Net Profit/Revenue
The quick ratio is a trimmed-down version of the current ratio. It is also known as the "acid test".
Although inventories are counted as current assets while calculating the current ratio, the same does not apply to quick ratio calculation. This is because the quick ratio is more of an indicator of the assets that the firm can liquify 'quickly'.
Quick Ratio = Current Assets - Inventories/Current Liabilities
As the name suggests, the inventory turnover ratio indicates how efficiently the inventory is being managed and turned into sales.
A very high inventory turnover ratio suggests that the inventory is fast-moving. The ratio also indicates if the business is wasting its resources and storage space on slow-moving, non-saleable inventory.
Investors and creditors often lay emphasis on this ratio since inventory is one of the highest reported assets that a firm has and can be used as collateral.
Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory
You can calculate the average inventory by adding the opening and closing inventory over a specified period and dividing the sum by 2.
The accounts receivable turnover ratio is crucial for businesses that are struggling to manage their working capital needs and the overall cash flow.
Also known as the "day sales ratio", it measures how quickly a firm is paid by calculating the time it takes for your firm to collect its accounts receivable.
Accounts Receivable Turnover Ratio = Net Credit Sales/Average Accounts Receivable
You can figure out the average accounts receivable by adding the opening and closing accounts receivable for the period under consideration and dividing the sum by 2.
As a small business, you must constantly monitor your business's current ratio, perhaps on a monthly or bi-monthly basis. It would allow you to assess its liquidity and make decisions on investments too.
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