A Fresh Look at the Current Ratio
Nothing keeps a business owner up at night like the fear of running out of cash. When facing a bank balance of $0, a business owner will immediately prioritize what must be paid to keep the lights on. Once the immediate crisis settles, when trying to determine the cause of distress a simple review of the income statement is never sufficient. This is where the current ratio comes in.
A simple calculation used to determine a firm’s solvency, the current ratio measures whether there are enough current assets to meet short-term obligations, i.e. if the firm will make payroll through the year. Because it is not uncommon to discover that many business owners are unfamiliar with the current ratio, it is prudent for lenders to ensure that their borrowers understand the calculation, the lender’s threshold requirements, and when trends in the ratio vary, strategies to quickly effectuate corrective performance measures.
How to calculate the Current Ratio?
Using figures pulled from the balance sheet, the formula for the current ratio is:
Current Ratio = Current Assets ÷ Current Liabilities
“Current” represents assets that can be converted to cash in less than a year and liabilities that are expected to settle in the next year. The most common current assets include inventory, accounts receivable and short-term investments, and the most common current liabilities include accounts payable, credit cards, lines of credit, the current portion of long-term debt, and accrued expenses such as payroll and vacation expenses.
If the information is available and credible, a target current ratio can be determined by benchmarking the ratio against other healthy firms in the industry. Regardless of the outcome, for any firm to avoid cash strains it is imperative that the ratio always remain safely above 1.0, as results below 1.0 indicate the firm will likely run out of cash sometime during the year. Alternatively, the ratio can also be too high particularly if the firm is hoarding cash that can be used to pay off debts.
Quickly Unlock Sources of Cash
When the current ratio is safely above the threshold but there is still limited cash to cover more immediate liabilities, it is prudent to engage in a comprehensive review of the inventory and accounts receivable, including inventory levels, inventory turn rates, and variances from optimal inventory levels, as well as accounts receivable balances, accounts receivable turn rates and average collection periods. Hidden sources of cash can be unlocked when inventory is sold at discounted rates in bulk, or if sufficient time is available, through a high-impact sales promotion. This strategy is particularly effective for retailers in the current climate. Also, alternative lenders can be engaged to lend against inventory balances and/or “factor” receivables.
By comparing current ratio trends over time and monitoring factors and adjustments that affect variances, a firm will be better prepared to take corrective actions prior to getting into a distressed or cash-strapped position. Likewise, when the current ratio trends are healthy, the firm will be able to meet lender threshold requirements, ensure other firms looking to do business that their bills will be paid, and when applicable, show that the firm is prepared to take on additional capital investments.