Blog

Ever felt like the term “current ratio” sounds like something straight out of a high school mathematics class that you’d rather forget? You’re not alone. But here’s the thing – understanding the current ratio can be a game-changer for managing your business’s financial health. Here’s a simple breakdown.

What is the Current Ratio?

In the simplest terms, this ratio measures your business’s ability to pay off its short-term obligations with its short-term assets. Think of it as a snapshot of your financial flexibility. A healthy ratio means you’re sitting pretty and can easily handle upcoming bills and expenses. A lower ratio? It’s a heads-up that you might need to take a closer look at your finances.

Inputs: the building blocks

To calculate the current ratio, you’ll need to know two things: your current assets and your current liabilities.
Current Assets

• Cash in the bank
• Accounts receivable, what your customers owe you
• Inventory

Current Liabilities

• Accounts payable, bills and expenses you need to pay
• Short-term debt, leases and business loans that are owed within twelve months
• Other short-term obligations, such as taxes, superannuation

The formula is quite simple, it uses the total of the items listed above and is applied as below:

Current Ratio = Current Assets / Current Liabilities

A worked example

Imagine your business has $150,000 in current assets and $75,000 in current liabilities. Apply those numbers into our formula, and you get a current ratio of 2. This means you have twice as many assets as liabilities, which is a s strong position to be in. It shows potential investors and lenders that you’re in a solid position.

Current Ratio vs. Quick Ratio

Not to complicate matters, but there is another ratio that is similar and easily confused with the current ratio.  The quick ratio provides a more conservative view, as it excludes inventory from assets since it’s not always quick to convert stock to cash. It gives you a stricter sense of your immediate financial health.

Knowing the difference helps you understand your liquidity from different angles, ensuring you’re not caught off guard.

Wrapping up

Keeping an eye on this metric can help you to manage your business more efficiently. A healthy current ratio varies by industry, but generally, a ratio between 1.5 and 3 is where you want to be.

By maintaining a healthy ratio, your business will be better able to withstand unexpected shocks, or the cash burn a business can experience when sales or work increases. Additionally, directors of a company have a duty to ensure that they do not trade while insolvent.

Not sure if your current ratio is where it should be or how to improve it? We can offer insights and strategies tailored to your business’s unique needs.

Would you like to know more?

For Expert Guidance for Your Business – Contact us at, enquiries@informba.com or call 03 9399 3769 for professional advice on business advisory, consulting, tax and accounting. Or alternatively, complete the contact form at the link below:

https://informba.com/contact-us/

Let’s discuss your next steps today.