What is the current ratio and how is it calculated?
The current ratio is a measure to gain insight into the liquidity of the company. The purpose of this liquidity ratio is to determine whether current financial obligations can be met in the short term. It involves the ratio between current assets plus cash and short-term liabilities.
The formula for calculating the current ratio is: current assets + cash / short-term liabilities.
Explanation of terms in the current ratio calculation
The current ratio is easily calculated using the company balance sheet, which lists the various values. It is useful to understand terms such as current assets, liquid assets, and short-term liabilities. Current assets may include inventory of products and accounts receivable with outstanding invoices. Cash includes cash on hand as well as funds in the bank. Short-term liabilities may involve a bank loan, fixed expenses such as rent, outstanding invoices from suppliers, and taxes yet to be paid.
Insight into the company’s liquidity
Calculating the current ratio reflects the liquidity of a company. The company balance sheet serves as the basis for the calculation. It is important to note that the result can vary daily. Any additional credits, for example, can change the outcome of the current ratio. To gain a clear understanding of the company’s liquidity, it is advisable to calculate the current ratio multiple times over a period.
Why calculate the current ratio?
Knowing the current ratio of a company is important in various situations. For instance, an investor may seek insight into your company’s financial situation and assess whether the company can meet its financial obligations in the short term. The current ratio provides insight and can offer investors and other lenders greater certainty. Additionally, optimizing debtor management and focusing on effective cash flow management can improve the current ratio.
In this case, you gain real-time insight into available funds. Effective cash flow management is not only ideal in the short term but also concerning determining future strategies. Optimizing the current ratio with accounts receivable management includes shortening payment terms for debtors and paying attention to invoice follow-up. With Payt, it is also possible to automatically follow up on invoices. It is also possible to consider selling unsuccessful inventory. To adjust the current ratio, it is essential to know when it is good or not.
When is the current ratio good?
The current ratio is considered good when the calculation result is above 1. If the result is below 1, it means that financial resources and/or inventory are less valuable than the debts. In this example, short-term liabilities are higher than current assets, suggesting that the company may not be able to meet all financial obligations in the short term. Typically, 1.5 is the average norm for a good current ratio, but an outcome of 1.8 is better. However, it is always possible to encounter a financial setback or find it challenging to convert inventory entirely into cash. Late or non-payment by debtors can also result in a lower current ratio.
It is important to note that the current ratio should be viewed in the context of the respective industry. Therefore, it is preferable to compare the result with the current ratio of companies in the same sector. Furthermore, a result below 1 indicates a risk, but it does not mean that the company will immediately go bankrupt. There are other options to obtain capital for the company. Also, a current ratio of 2 is not always considered favorable. It indicates that there are many current assets within the company or that there are many outstanding receivables, making it difficult to collect money from debtors. It is essential to know that calculating the current ratio is a snapshot and subject to change.
Schedule an online demo
Curious about the benefits of Payt for your organisation? Schedule your personal online demo with Aziz! You will receive an interactive demonstration of our platform for accounts receivable management, without any obligations.