Accounting 101: What is ‘Current Ratio’?
Whether you are a small business owner or professional accountant, you’ve probably come across the term “current ratio.” Based on the name alone, it’s difficult to determine what exactly current ratio means. So today we’re going to take a closer look at this term, revealing its true definition and how it relates to accounting.
In the most basic sense, current ratio refers to the liquidity and efficiency ratio of a business’s ability to pay off its short-term debt. Regardless of industry, all businesses need to pay close attention to their current ratio. If a small business has too many liabilities and not enough assets, it may struggle to turn a profit, let alone grow.
A business’s assets may include cash, stock and bonds, securities, etc., whereas liabilities include any type of debt.
So, how do you calculate current ratio? It’s actually easier than you may think: simply take your business’s current assets and divide that number by its current liabilities. You now have your current ratio. Here’s an example: assuming your assets are $10,000 and your debt is $50,000, you would divide $10,000 by $50,000 to get a current ratio of .20 (20%). It’s a simple formula that’s particularly relevant for small business owners, many of whom must balance a fine line between generating revenue and paying off their debt.
Current ratio is also used by investors and lenders to determine whether or not a business owner is a suitable candidate for a loan. If a small business owner with a higher-than-average current ratio approaches a bank for a loan, that bank is more likely to approve the loan because of the high current ratio. A low current ratio, on the other hand, indicates the small business owner has more debt and less assets, making him or her a less-than-ideal candidate for a loan. This is why it’s important for small business owners to constantly work on improving their current ratio, which is done by increasing assets and reducing short-term debt.
Hopefully, this will give you a better understanding of current ratio. To recap, it refers to a business’s total assets divided by its short-term liabilities. Current ratio is used in many different applications, although it’s most commonly used by lenders when determining whether or not to loan money to a business owner or entrepreneur.