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What is the current ratio?

The current ratio indicates the proportional ratio of current assets to current liabilities. Current ratio calculations are typically used as an analytical indicator of a small business’s current liquidity. Essentially, a company that has a significant amount of current assets with a very small amount of current liabilities provides some degree of assurance that any obligations owed by the company will be paid. Thus, a higher ratio of assets to liabilities is greatly preferred for a majority of small businesses.

Example

For example, if a particular company has current assets worth approximately $800,000 and current liabilities totaling $200,000, then, the company’s current ratio is 4:1. Inversely, if a company has current assets worth approximately $200,000 and its current liabilities are $600,000, then, the company’s current ratio is 1:3. The latter example indicates insolvency as most accountants feel a current ratio less than 1:1 is an indicator of a struggling business.

Let's dig deeper

It is important to note that your small business’s current ratio should be analyzed with ratios of other businesses in the same respective industry.  When comparing your current ratio against another business’s current ratio, it would be prudent to look at the current ratio’s trend over time.  This helps in analyzing the current state of other small businesses within the respective industry as an improving current ratio over time may be an indicator of better financial decisions within the company and/or overall market growth in the respective industry.

The composition of a small business’s assets are crucial in determining the overall value of a business’s current assets.  If the majority of a company’s assets are staked in cash, collectible accounts receivable, and marketable securities, this is an encouraging sign of liquidity in the company.

Inversely, if a majority of a small business’s assets are staked in inventory that does not move quickly and uncollectable accounts receivable, this may be an indicator that the business’s assets may not be available to cover unforeseen liabilities in the short term.


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