The Current Ratio Matters

In the posting Necessity of Working Capital we looked at the importance of having adequate working capital. For that purpose we considered how working capital is calculated and how the amount can impact a business for good or bad. Now let’s look at working capital a different way.

Current Ratio

The current ratio is really just another way of analyzing working capital. The calculation is simply Current Assets divided by Current Liabilities. Rather than looking at a gross dollar number for working capital, this attempts to quantify the relationship of current assets to current liabilities. I think you will soon see why the current ratio matters so much as a way to assess the financial health of a company and get an idea as to whether there is sufficient liquidity.

Some Examples

Using the same numbers we used when calculating working capital let’s now see how they look as a current ratio. Remember we divide current assets by current liabilities.
current ratioAs you can see, in example one the company appears to have plenty of current assets compared to the current liabilities. In example two the current ratio demonstrates that this company also appears able to meet obligations when due but it is not as certain. In example three you see a company on shaky financial footing when it comes to paying current obligations as due. Unless something is done to change this via more diligent management or an influx of capital, the company may become insolvent. Looked at together, I believe you will see why the current ratio matters when it comes to being viable.

The Bottom Line

In the examples above, just as when we examined the working capital in dollar terms, we have not considered the quality of current assets or the near-term obligations (like payroll) that will need to be paid and are not already recorded in the current liabilities. All of this needs to be considered when using the current ratio to estimate financial strength.

Do you have a clear understanding of why the current ratio matters? If you need help understanding this and how you can impact the current ratio, please contact AimCFO and let us help you.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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