Everything You Always Wanted to Know About Current Ratio but Were Afraid to Ask
Editor’s Note: This is one of an eight-part series about key financial terms all entrepreneurs should know.
Current ratio is an important liquidity ratio that investors and potential investors care about — which means business owners need to care about it, too. Here’s the break down of what you need to know along with expert advice on what your current ratio says about your business.
What is current ratio?
The current ratio, also known as the working capital ratio, measures a company’s ability to pay off its short-term liabilities with its current assets. In other words, it’s a barometer of how much the working capital you have on hand is earmarked for payments. To calculate your current ratio, divide your current assets by your current liabilities.
Why is current ratio important?
Current ratio, taken together with other liquidity ratios, offers investors a snapshot into how your company may perform for the immediate future. Generally speaking, the higher the ratio, the more working capital, the better the company’s health. A ratio below one means a company has more liabilities (debt) than assets. In industries where companies have a lot of assets tied up in inventory, like retail for example, ratios are typically lower.
How can current ratio impact your ability to raise capital?
Current ratio is one of many ratios a potential investor will examine when making a funding determination. Because of the variance of payment terms from industry to industry, current ratio alone is not enough to make a funding decision.
As an entrepreneur, it may help to understand how your current ratio compares to other companies within your industry, and what factors in the near- and medium-term future might impact it significantly. For example, if you’re about to take on a significant amount of debt, or get extended payment terms with a supplier that will shift debt from your short-term to your long-term obligations on your balance sheet, your current ratio might change substantially. Be prepared to answer questions about these or other possibilities when discussing your current ratio with your CPA or CFO.
Strategic Funding asks an expert about current ratios:
In our interview with accounting professional Brad Shanahan, COO/CFO of VitaPerk – the world’s first nutrient coffee enhancer – he breaks down the importance of current ratio and gives startups a bar for which they should aim.
Why is the current ratio an important barometer of a company’s health to potential investors?
Brand Shanahan: The current ratio identifies a company’s ability to pay back its liabilities with its assets, or in other words, its liquidity. The current ratio gives a sense of the efficiency of a company’s operating cycle, its ability to turn its product into cash and its ability to pay its debts.
Is there a current ratio range startups should target to increase long-term viability?
Brad Shanahan: A good range is between 1.2 to 2. A ratio equal to 1 indicates that current assets are equal to current liabilities and that a company is just able to cover all of its short-term obligations, so you want to be above that. A current ratio of 2 is ideal.
How would you rate your financial-terms literacy? There are many more ratios it helps to be “current” on if you plan to raise money in the near future. Don’t forget to check out part 1 of this series, which focuses on Debt-to-Income Ratio.