A reminder on the current ratio
One of the biggest fears of a small business owner is running out of money. But large companies in financial difficulty face the same risk. To find out if a business is really on the verge of reaching a $ 0 balance in its accounts, you can’t just look at the income statement. You need to perform a simple calculation using a few numbers.
This is where the current ratio comes in. I spoke with Joe Knight, author of HBR TOOLS: Return on Investment and co-founder and owner of www.business-literacy.com, to learn more about these financial conditions.
What is the current report?
It’s one of the many liquidity ratios that measure whether you have enough cash to make payroll in the coming year, says Knight. The current ratio measures a company’s ability to repay its short-term debt with its current assets. It’s closely related to the quick report, which is often referred to as the “acid test” because people use it to understand “if things got really bad, could you stay afloat? “
How do you calculate it?
The formula for the current ratio looks like this:
Note that “current” in financial terms means a period of less than one year. So your current assets are things that you could convert to cash within the year. They include cash on hand and short-term investments. They can also include your accounts receivable, inventory, and accrual payments, depending on your business. For example, accounts receivable may not seem like it can be liquidated quickly, but there are third parties, Knight explains, who will buy a company’s accounts receivable in certain industries. It’s called “factoring”. The rapid clearance of inventory may also depend on the industry. “Look at Goodyear,” says Knight. “The chances of selling a million dollars worth of rubber quickly are slim.”
Your current liabilities are things that you plan to settle over the next year. “One of the biggest liabilities on the income statement is accrued liabilities,” explains Knight. These are the amounts you owe others but have not yet reached your accounts payable liabilities. One of the most important of these expenses for businesses is payroll and vacations. You owe employees for their time, but they never charge your business, so it doesn’t affect accounts payable.
Here is an example of how the calculation is performed. If your business has $ 2,750 in current assets and owes $ 1,174 in current liabilities (again, you can pull these numbers off your business’s balance sheet), then the current ratio is:
(Note that the ratio is usually not expressed as a percentage)
As with the debt-to-equity ratio, you want your current ratio to be in a reasonable range, but it “should always be safely above 1.0,” says Knight. “With a current ratio below 1, you know you’re going to run out of cash for the next year or so, unless you find a way to generate faster. “
But the ratio can also be too high. The current ratio for Google and Apple “has exploded,” says Knight. “Apple’s current ratio recently was around 10 or 12 because they’ve amassed a treasure trove of money.” But investors are getting impatient, saying, “We didn’t buy your shares to let you tie up our money. Give it back to us. And then you are able to pay dividends or buy back shares from your investors.
Now let’s take a look at the closely related quick report formula:
Note that the quick ratio is the same as the current ratio with inventory removed. Why? As noted above, stocks can be hard to sell, so when you subtract them, almost all of the rest of the liability is cash or easily turned into cash. “So that ratio will tell you how easy it would be for a company to pay off their short-term debt without waiting to sell their inventory,” says Knight. “For businesses that have a lot of money tied up in inventory, lenders and sellers will look at their ratios quickly.” However, most people will watch the two together, says Knight, often comparing the two.
How do companies use it?
Knight says it’s the first ratio he uses when considering whether to invest in a business because it quickly tells him how creditworthy the business is. “I would continue to watch others, of course, but that would give me a sense of where the business is going. “
Bankers pay close attention to this ratio and, as with other ratios, may even include in loan documents a current threshold ratio that borrowers must maintain. Most require it to be 1.1 or higher, Knight says, although some banks can go as low as 1.05. “If you are below 1, you will quickly be refused,” he says.
Managers may not be monitoring the current or fast ratio every day, but they can have a big impact on it. “A lot of current liabilities are touched or managed by individuals in the company,” he explains. These include accounts payable, accrued vacation, deferred income, inventory, and receivables. So if your job involves managing any of these assets or liabilities, you need to know how your actions and decisions might affect the company’s current ratio. Even, for example, if you allow your team to accumulate vacation time, it can impact those numbers.
This ratio can be useful for people outside your company who are looking to do business with you. Potential partners can use it to understand how creditworthy you are. Suppliers might want to know if their bills will be paid and customers might want to know how long they can do business with you if they are relying on your product or service.
Of course, private companies do not advertise their current or quick ratios, so this information is not immediately available to everyone. “Whether you get this information about a company or a potential partner depends on the leverage you have on them,” says Knight.
What mistakes do people make when using the current ratio?
These are relatively simple calculations to do. The tricky part is deciding what to include in the numbers. “There are many different ways to calculate current assets and liabilities and just as many ways to rig the numbers if you want to,” says Knight. “So if you’re outside of a business and you look inside, you never know if they’re telling the truth. In fact, he says, you often don’t know what you’re looking at. “When you review a return, you are examining the competence and integrity of the management team that prepared it. So, he says, it’s not a number you can easily compare with other companies. What you hope is that in a well run business you can compare trends over time to see how that business is performing.