What Is a Good Current Ratio? Understanding Liquidity for Colorado Small Businesses
Chances are, you have already come across the term ‘current ratio’ while reviewing your business’s finances with the accountant or a financial manager. It is a significant metric that provides deep insights into a business’s financial status. No wonder banks and financial institutions check the financial health of a business through this lens while processing a loan application.
What Is the Current Ratio?
The current ratio is a metric that measures the short-term liquidity of a business. This value indicates the business’s ability to pay its short-term liabilities by quickly converting assets into cash.
Mathematically, the current ratio formula is current assets divided by current liabilities. The higher the ratio, the higher the liquidity of the company. For example, a current ratio of 3 indicates that the company has thrice as many current assets as current liabilities.
Consider that your company has $75,000 in current assets and $40,000 in current liabilities. The current ratio stands at: $75,000 ÷ $40,000 = 1.87
A current ratio lower than the industry average indicates that there is a higher risk of the company getting into financial distress or defaulting on obligations. The current ratio is often referred to as the working capital ratio, as it is closely retalted to business working capital.
What Counts as Current Assets and Liabilities?
Understanding the accounting basics will help you know about the concept of assets and liabilities. Current assets are company-owned assets that can be easily sold or liquidated, usually within a year. These include cash, current bank account, petty cash, accounts receivable, stock inventory, and marketable securities. Remember, assets like land and buildings are considered long-term assets as they may not be converted into cash within a year.
These assets determine your business’s short-term liquidity and project the future financial health. Current assets play an important role in determining your business capital and regulating the cash flow. During tough times, these assets will help in risk management.
In contrast, current liabilities indicate what a business owes and its financial obligations that need to be settled within a year. You can also consider them as short-term debts that can generate a future outflow of cash. These include accounts payable, short-term debt, taxes payable, payroll due, rental fees, and accrued expenses.
When the company’s balance sheet is put together, both current assets and liabilities are indicated. These numbers are analyzed by investors and creditors to determine the company’s financial solvency and its ability to pay back a loan.
What Is Considered a “Good” Current Ratio?
Generally, a current ratio between 1.5 and 3.0 is considered healthy. If the current ratio is 1.0, then your business is at risk, as there is no surplus capital to manage emergencies. If the ratio drops below one, then the current liabilities of the business exceed its current assets. This indicates a precarious financial scenario.
At the same time, a very high current ratio above 3.0 can be an indicator that the company’s assets or capital are not being used efficiently. The excess capital can be invested back in the business to buy equipment or software for enhancing efficiency.
However, the ideal current ratios vary across industries as each sector has a different financial structure. Businesses with lower capital requirements, stable revenue streams, or quick turnover rates might have lower current ratios. On the other hand, asset-heavy or research-based businesses with longer receivable cycles may have higher current ratios.
For example, advertising and marketing services have an average current ratio of around 3.64. Whereas the food retail industry has an average current ratio of 1.21. In some industries, like manufacturing, the current ratio varies based on the type of production.
Why the Current Ratio Matters for Business Owners
Examining the current ratio can be a quick health check for your small business. A healthy ratio indicates that your business has enough liquidity and the ability to cover short-term liabilities. This means your business will stay afloat even if things get ugly.
Checking the ratio regularly will help you spot cash flow issues and plan for upcoming expenses. With an above-average current ratio, you have a better chance of securing loans from lenders. Moreover, this is the first ratio that investors check before deciding to invest in your business.
Current Ratio Trends and Why One Snapshot Isn’t Enough
Monitoring the current ratio over time assists with proactive decision-making. If you observe the ratio going down steadily, it is a red flag, and corrective measures are needed. That said, there can be seasonal fluctuations affecting the inventory turnover or accounts receivable. For instance, a booming economy can cause a sales increase, driving up the ratio. Constant monitoring of the trend allows you to make a balanced interpretation of the underlying financial conditions.
A trend analysis of the ratio registering a rise over time indicates rising liquidity. Conversely, a falling ratio over time is a sign of a liquidity issue that may need further investigation. The trend plays a crucial role in taking important business decisions related to investment, debt management, and inventory.
How to Improve Your Current Ratio
If your current ratio is below the average, there are a few practical strategies that you can use to improve it.
- Reduce overhead expenses and short-term liabilities like rent, utilities, and insurance. Spend time negotiating for longer payment terms and shop around for other options. Negotiating interest rates can also help you reduce the business’s cost of debt.
- Sell any unused assets to increase cash in hand and available working capital. Likewise, reducing excess inventory through more efficient inventory management can boost cash reserves and increase current assets.
- Converting short-term debts into long-term debts will give you more time to make payments. However, make sure to keep long-term financial strains in mind.
- Using financial tools and leveraging the power of data analytics can assist in real-time liquidity management and provide quick cash flow insights. This allows you to make informed strategic decisions to improve the current ratio.
Current Ratio vs. Other Liquidity Metrics
While the current ratio is an important tool, it is not without some limitations. A complete analysis of a business’s financial health requires interpreting it in conjunction with other liquidity metrics like the quick ratio and cash ratio.
The quick ratio formula is similar to the current ratio, but only the most liquid assets are considered current assets. These are quick assets that can be converted into cash within 90 days and exclude assets like inventories.
Cash ratio is the ratio of cash and cash equivalents divided by current liabilities. These assets include cash in hand, savings accounts, treasury bills, etc. Cash ratio measures the ability to meet sudden obligations without selling other company assets.
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Final Thoughts
A healthy current ratio is a prime indicator of your business’s resilience and increases its attractiveness to investors. However, it is not the single key factor that you need to focus on while growing your business in Denver, Colorado. No matter the liquidity ratio formula you use, the ultimate goal is to ensure a financially sound business structure that is sustainable.
If you need strategic support to manage the ebbs and flows of working capital, the Energize Colorado team can provide support through resources and advice. Check out the Energize Community Program that has been designed to help Colorado small business owners build strong financial foundations and run a successful business.