What is a Good Current Ratio?
One of the worst things that can happen to a small business owner is to run out of cash. Knowing how much cash you have isn’t always a matter of opening your till. Your cash is tied up in lots of things, like inventory, payment transfers, assets, and more.
If you want to know if you have enough cash to keep your business running, you’ll want to check your current ratio.
Here’s how to know if you have a good current ratio or not.
What is a current ratio?
The current ratio is a number, usually expressed between 0 and up, that lets a business know whether they have enough cash to service their immediate debts and liabilities. The term “current” usually reflects a period of about 12 months.
If your current ratio is high, it means you have enough cash. The higher the ratio is, the more capable you are of paying off your debts. Big companies like Amazon and Microsoft usually have quite a lot of cash, and so tend to have higher current ratios.
If your current ratio is low, it means you will have a difficult time paying your immediate debts and liabilities.
In general, a current ratio of 1 or higher is considered good, and anything lower than 1 is a cause for concern. However, good current ratios will be different from industry to industry.
How do I calculate the current ratio?
In order to calculate your current ratio, you need to compare your company’s assets and liabilities.
Review your company’s balance sheets and other reports. Include your cash, accounts receivable, the value of your inventory, and other items that could be turned into cash in the coming year.
Your liabilities include accounts payable, wages, taxes, and any debts that you have to pay back, either in full or in part, during the next year.
To find your current ratio, divide your assets by your liabilities like so:
Let’s say a company has assets valued at around £200,000, and their liabilities were valued at £180,000. If you divided their assets by their liabilities, you would get a current ratio of 1.11. Because the company liabilities due in a year are less than the company’s current assets, it will most likely have enough cash to service its current liabilities.
While it might seem like you need as high a current ratio as possible, that isn’t necessarily the case. If a company had a very high current ratio, like 4 or higher, it could indicate that the company may not be using its assets and capital to effectively generate more business.
Is the current ratio important?
The current ratio can be very important for some businesses to get a picture of how they are managing financially during the current year. It lets the company know how liquid the company is and provides an impression of the financial health of the business. This information can be particularly interesting to lenders and investors because it lets them see the current state of the company expressed as a definite number.
What makes the current ratio more valuable still is its expression over time. Current ratios can fluctuate year on year for a variety of reasons, and a low current ratio may not accurately reflect the value of a company. However, a current ratio that consistently decreases over time may be of concern to potential investors.
What is a good current ratio?
In general, a good current ratio is anything over 1, with 1.5 to 2 being the ideal. If this is the case, the company has more than enough cash to meet its liabilities while using its capital effectively.
That being said, how good a current ratio is depends on the type of company you’re talking about. It might be very common in certain industries to have current ratios lower than 1. Supermarkets, for instance, tend to operate at current ratios below 1 because they have few trade receivables, have a high level of trade payables, and have tight cash control.
Another company that may surprise you to have a small current ratio is Wal-Mart [1]. This is because the company has a very high level of inventory. However, Wal-Mart is very good at turning their inventory and collecting the receivables, so they can operate with a low current ratio and still post massive profits.
It’s also important to compare the business in question to other businesses in their industry. If the current ratio for the business in question is lower than the industry average, that may indicate some serious cash flow problems.
Keeping track of your current ratio
You’ll want to keep an eye on your current ratio. Not only is it something you’ll want to show investors if you’re doing well, but it will give you an insight into how your business is performing over time.
To keep track of your current ratio, you can use accounting apps and software like Xero to help you keep track of your finances, and streamline and automate finance management processes.
Doing this will ensure you know where your company stands financially and how your company may look to investors as a potential investment. With apps like Xero, you can also automate things like accounts payable, invoicing, tax payments, and bank transactions.
Limitations of the current ratio
Of course, the current ratio isn’t a magic bullet, and it alone can’t give a complete picture of your company’s financial health.
The current ratio alone will not likely be sufficient to assess a company’s short-term liquidity, for example. The current ratio accounts for all the current assets of a company without considering that some assets may be harder to convert to cash than others. Inventory can be very difficult to convert to cash than accounts receivable. Therefore, the liquidity of the company may be better than the current ratio suggests.
The current ratio also only expresses the financial position of a company at the current time, and won’t give a complete picture of the company’s liquidity and solvency.
Other ratios you can use to determine your company’s financial health are:
- The quick ratio: similar to the current ratio, but takes more liquid current assets into account.
- The cash ratio: this compares the cash and cash equivalents to a company’s short-term obligations.
- The operating cash flow ratio: compares a company’s active cash flow from operations to its current liabilities.
Keep track of your company financials from your POS
It’s vital to keep a constant eye on your books. When you don’t, you’re likely to let things slide.
With Epos Now systems, you can easily keep track of the flow of cash through your business. With integration with all the best-known accounting apps, like Xero, Quickbooks, and Sage Business Cloud, you can manage all your financials right from your POS systems.
With accounting integrations on your POS, you can:
- Automate common accounting processes, like invoicing and payments
- Manage your accounts from anywhere
- Synchronize POS data with your accounting software
- Secure your financial data on the cloud
- Submit tax returns automatically
- Effectively manage payroll and merge payroll data with other accounts
Contact Epos Now for more information about our systems.
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