As a growing business, your current ratio is an important indicator of financial health. This financial metric is often used by investors and potential lenders to judge how easily a company can meet its upcoming financial obligations. Therefore, ensuring you have a positive current ratio is vital for any business looking at expansion.
Ethel & Em is an online and physical retailer of wool and knitting supplies. The company started with investment from founder Melanie McKay, but is now looking to expand by increasing its presence both online and in-store, including moving to larger premises.
“My background is in mid-size retail," says McKay. “With that in mind, I’ve had accountants and have been tracking financial ratios since we started in 2018.”
What is the current ratio?
The current ratio is a figure that compares your company’s current assets to its current liabilities, explains Alex Walsh, an SME advisor and executive audit accountant with Rayner Essex. “Banks and financial institutions will use the current ratio to understand whether your company is at risk of defaulting on commitments or is a good candidate for a loan or other financing,” he says.
Crucially, the current ratio focuses on short-term obligations, Walsh adds. “Your assets would include things like cash, stock and debtors, while trade creditors, VAT and PAYE would be short-term obligations. A long-term obligation such as long-term credit would be excluded from the current ratio.”
For Ethel & Em, maintaining a healthy balance between liabilities and assets can be challenging. Wool suppliers can have enormously different lead times and payment terms, meaning the business needs cash to invest in new stock year-round. Ensuring the company has the working capital required, while also taking a cautious approach to its liabilities is important, says McKay. “We are very cautious and try to keep to a current ratio of two,” she says. “If I know that we have a quarterly VAT liability of £5,000 then I want to ensure there is £10,000 set aside, because we are too small to get caught out.”
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Formula and calculation for the current ratio
To work out the current ratio, you need to divide current assets by current liabilities:
Current ratio = current assets / current liabilities
The current assets of a company are the assets that are easily convertible into cash within a period of one year. Current liabilities are expenses that must be paid within one year and could include staff costs, short-term debts, tax, PAYE and dividends.
Examples using the current ratio
A typical current ratio
Company A is a double glazing firm that has £50,000 of inventory plus £100,000 in current cash reserves, and outstanding accounts receivable of £120,000. Over the coming year, the company needs to pay £80,000 in tax and PAYE liabilities, plus £70,000 in staff costs.
This means the company’s current ratio is calculated as follows:
Current ratio = £270,000 (assets) / £150,000 (liabilities)
The company’s current ratio is 1.8, meaning it could potentially pay its short-term liabilities 1.8 times using current assets. A current ratio between 1.5 and 3 is considered typical for most industries.
A high current ratio
Company B is a graphic design agency, which does not hold stock. However, the company has £300,000 in accounts receivable and liabilities of only £40,000 in tax and PAYE, plus £20,000 in payroll costs and a £5,000 loan payment due this year.
This means the company’s current ratio would be calculated as:
Current ratio = £300,000 (assets) / £65,000 (liabilities)
The company’s current ratio is around 4.6, which is considered high. This might at first glance look like a good thing, but a current ratio this high might show that the company is not using its capital appropriately, which could be restricting its growth and viability.
A low current ratio
Company C is a gardening firm. The company has stock worth around £10,000 and outstanding accounts receivables of £20,000. Over the next year, the company will pay £20,000 in tax, VAT and PAYE and will also pay off the balance on a finance agreement for equipment totalling £10,000.
This means the company’s current ratio is as follows:
Current ratio = £30,000 (assets) / £30,000 (liabilities)
The company’s current ratio is 0, which is considered low. This figure shows the company might be at risk of insolvency because it cannot guarantee to meet upcoming financial obligations.
What is a good current ratio for my company?
In general, a current ratio of between 1.5 and 3 suggests that a company is well able to meet its short-term obligations. A firm that has a current ratio of below 1.0 or 1.5 could represent a higher risk that the company will not be able to meet its obligations and could become insolvent.
However, a current ratio of more than 3 might suggest the company is carrying too much cash. This sounds like a positive, but too much cash is often a problem because it means the company is not taking the opportunity to invest to support increased growth and profitability while increasing the cost of capital.
Current ratio vs quick ratio
In some circumstances, you might replace the current ratio with the quick ratio. While the current ratio considers certain expenses and liabilities over a period of 12 months, the quick ratio considers expenses vs liabilities excluding inventory, focusing instead on cash and other assets that can be quickly converted into cash.
“A quick ratio is useful if you need to know how well a company might be able to meet obligations if there was a dramatic change in market conditions because it focuses on what cash a company can generate in a short period of time,” says Walsh.
Problems with the current ratio
The current ratio is most useful for companies seeking funding such as bank finance or external investment and can have little bearing on the day-to-day running of a business.
“At the moment, [our] company is self-funded so there are other numbers that are more important than the current ratio,” says McKay. “I can track working capital, and I need to know what is going in and coming out, so we generate a monthly payables report to ensure we have the awareness of what orders are coming in, versus what we are spending.”
Walsh adds that the current ratio formula might not always show the full risk of a company running out of cash, because it includes inventory that might not convert to cash quickly enough or at a high-enough price to meet short-term obligations. A more accurate picture of a company's cash situation can be achieved by predicting its cash flow.
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