Current Ratio

The current ratio is an inappropriate relationship to use or rely on in small business.   The ratio is best suited for large publicly traded organizations.   This article explains the basic formula for the current ratio, how to identify the ratio in reading financial statements, its purpose and the many drawbacks for its use with small business.   Finally some alternative measurement tools are presented for use in small business evaluation instead of the current ratio.

Basic Formula – Current Ratio

One of the primary business requirements is the payment of bills (accounts payable) and other operational costs (labor, taxes, facilities, office expenses etc.) on a regular basis (weekly and monthly).  These costs are commonly referred to as current liabilities (due within one accounting cycle – a month, quarter or a year).   Current assets, specifically cash, are used to fulfill the payment of current liabilities.   Naturally the more current assets in existence, the easier and the likelier the current liabilities will get paid in a timely fashion.

The formula is relatively simple and easy to understand:

.   Current Ratio =  Current Assets    .
.                              Current Liabilities

It is commonly quoted as a value to another value in its simplest mathematical state, like 3 to 1 or 3:1.   This means there are three times as many current assets as there are liabilities.   A 3:1 ratio is very good.   Large publically traded companies typically carry ratios of 4:1 or higher.  Small businesses often have ratios of 2:1 or less.

Because current assets comprise more than just cash, it is often difficult to meet the timing requirements of the various short-term obligations.   Vendors and suppliers want cash as payment.   To understand this, let’s illustrate the formula after reading a simple set of financials.

Calculate the Ratio

The following is an example balance sheet to illustrate the formula and then explain some issues associated with using the current ratio in small business.

.                          DIAMOND TIRE CENTER
.                                 Balance Sheet
.                            November 30, 2015
ASSETS
Current Assets
.     Cash                                 $27,000
.     Inventory                           42,000
.     Accounts Receivable         18,000
.     Prepaids                               2,100
.     Sub-Total Current Assets                $89,100
Fixed Assets                                          107,000
Other Assets                                            14,000
TOTAL ASSETS                               $210,100


LIABILITIES
Current Liabilities
.    Accounts Payable             $51,000
.    Accrued Payroll                    6,000
.    Accrued Expenses                9,300
.    Current Portion L/T Debt     3,600
.    Sub-Total Current Liabilities           $69,900
Long-Term Debt                                      58,000
TOTAL LIABILITIES                        127,900
EQUITY
.     Common Stock                $20,000
.     Retained Earnings              46,000
.     Current Earnings                16,200
.     Sub-Total Equity                                 82,200
TOTAL LIABILITIES & EQUITY  $210,100

The formula requires two values, current assets and current liabilities.    The result is:

.      Current Ratio = Current Assets      .
.                                Current Liabilities

.      Current Ratio = $89,100
.                                $69,900

.      Current Ratio = 1.27:1

So a question exists, is this a good or poor current ratio?   I will reiterate my opening statement; ‘The current ratio is an inappropriate relationship to use or rely on in small business’.   The drawbacks explained below will confirm this statement.   For now, this section is simply illustrating how to calculate the ratio by reading the financial statement (balance sheet).

To comprehend the merit of this ratio, the reader must first understand its purpose.

Purpose of the Current Ratio

Most business individuals use the tool to evaluate the short-term ability of a business to continue operations.   The higher the ratio the longer the business can operate without some form of working capital infusion.   More sophisticated business investors use the ratio to compare similar investments and the short-term financial strength.   Again, this is referring to publically traded corporations like mid-caps and large cap companies.   Penny stock investments are still too small to utilize the current ratio as a reliable decision tool for investment purposes.

The following is a list of various uses of the ratio; some of which have been explained.

A) It can be used as a comparison tool to evaluate short-term financial strength of a publically traded company.
B) It is also a mathematical derivative identifying the number of accounting cycles (one month, quarter or a year) that a business can meet its financial obligations without an infusion of working capital or the profit from the sale of products/services.
C) A very common use is as a measurement against a standard for an industry of management’s ability to manage cash flows from operations.
D) The current ratio acts as an indicator of profit capacity from operations by evaluating the ratio over several cycles.  An increase indicates profitable operations.
E) Finally, when used with the other 20 plus business ratios it can help determine the likelihood of success for long-term stock purchases or sales.

The ratio is restricted to a limited scope of business financial status.   Thus for small business its drawbacks overshadow any information gleamed from its value as explained below.

Drawbacks of the Current Ratio in Small Business

As stated before, the current ratio is inappropriate when referring to small business.   The primary reason is economy of scale.   To illustrate this, look at the ratio when a small business pays its accounts payable.   In this case, the business pays $10,000 of its accounts payable.

.                                   ABC Inc.
.      Balance Sheet (Limited Scope – Summary Format)
.              December 30 and 31, 2015
.                             Before 12/30/15       After 12/31/15
Current Assets           $51,000                   $41,000
Current Liabilities       17,000                       7,000
Current Ratio                3:1                          5.85:1

Notice that after paying $10,000 in accounts payable one day later, the ratio is an impressive 5.85:1, nearly double the day before.

Now, let’s see what happens when the magnitude of the balance sheet is 10 times the volume and the business pays one week’s worth of liabilities (25%) as a function of its regular accounts payable management.

.                                           ABC Inc.
.              Balance Sheet (Limited Scope – Summary Format)
.                    December 30 and 31, 2015
.                                     Before                         After
.                             December 30, 2015     December 31, 2015
Current Assets              $510,000                  $467,500
Current Liabilities          170,000                    127,500
Current Ratio                     3:1                          3.66:1

This simple scaling by 10 of the balance sheet and managing the accounts payable with normal financial management reduces the volatility of the current ratio significantly.   In effect, the small business environment allows for greater dispersion of the ratio than in the larger corporate financial structure.   The economy of scale dampens the ability to manipulate the current ratio.

So the lack of economy of scale with small business creates the ability to more easily manipulate the current ratio results.   It is the number one drawback to using the current ratio when evaluating small business operations.    Another drawback to the current ratio is the increasing of liabilities in a one to one relationship with current assets.   Assume the same case as in the small business example above, except now, of the $51,000 of current assets there is little cash.   So the company uses its line of credit to increase cash by $10,000.   Remember a line of credit is a current liability.   Now let’s look at the results.

.                                      ABC Inc.
.                   Balance Sheet (Limited Scope – Summary Format)
.                     December 30 and 31, 2015
.                                   Before            After
                                  12/30/15        12/31/15
Current Assets           $51,000         $61,000
Current Liabilities       17,000           27,000
Current Ratio                 3:1               2.26:1

The current ratio decreases by 25%.   Think about this for a moment, 25% change in one day is very volatile.

A third drawback to this ratio is the relationship of the current assets, especially in small business.   In more mature operations, cash flow is more reliable and it becomes easier to manage and fund regular operations, so cash dominates current assets.  But in small business cash tends toward a much weaker percentage of total current assets.   It is used to fund growth and thus there is more demand for its use depleting the cash account.   The current ratio uses all the current assets to determine the derivative.   A larger company can change the ratio by simply paying down its accounts payable whereas a smaller business can’t demonstrate significant improvement without additional cash.   Take a look at this illustration.

Before Changes
Balance Sheets (Limited Scope)
December 30, 2015

.                                         ABC Inc.        XYZ Inc.
,                                                                                  (Larger Operation)

Current Assets
.    Cash                               $4,000          $300,000
.    A/R                                47,000             210,000
Total Current Assets         $51,000           $510,000

Current Liabilities
.    Accounts Payable          $15,000         $150,000
.    Accrued Expenses             2,000             20,000
Total Current Liabilities     $17,000         $170,000
Current Ratio                          3:1                    3:1

After Changes
Balance Sheets (Limited Scope)
December 31, 2015

.                                          ABC Inc.       XYZ Inc.
.                                                            (Larger Operation)

Current Assets
.    Cash                               $   -0-              $150,000
.    A/R                                 47,000              210,000
Total Current Assets          $47,000            $360,000

Current Liabilities
.    Accounts Payable          $11,000           $     -0-
.    Accrued Expenses             2,000              20,000
Total Current Liabilities     $13,000            $20,000
Current Ratio                        3.61:1               18:1

Although the ratio is acceptable, there is no cash to pay the bills; whereas in larger operations, cash is still available to pay the bills.

So if the ratio is easily manipulated or unreliable in small business financial analysis; are there alternative methods to evaluate short-term financial health?

Alternative Methods to the Current Ratio

The primary purpose of the current ratio is understanding the short-term financial health of an operation.   It is a risk evaluation tool.   Any owner or investor is concerned that the business may become insolvent or worse bankrupt.   So other tools are used to evaluate this risk with small businesses.   Below are alternative tools (methods); it is best that they are used together and not individually as a barometer of short-term financial health.

A)  Net Current Asset Trend – This simple mathematical subtraction formula of current assets minus current liabilities establishes an absolute dollar value of short-term financial position.   This value is calculated regularly, daily is best, and a trend line is charted.   If this line has a positive slope, then it is a good indicator of continuous improvement.   The steeper the slope, the better.

B) Cash Ratio – A ratio of cash to current liabilities, it is always lower than the current ratio (current ratio includes all current assets).   However, it is a good indicator of ability to meet the cash needs of the company.

C) Quick Ratio (Acid Test Ratio) – This ratio excludes inventory and those liabilities not needing payment within the thirty day traditional accounting cycle used in small business.   It is more restrictive than the current ratio and therefore less manipulative thus making it more reliable.

D) Combination of Inventory and Accounts Receivable Turnover Rates – Both inventory and accounts receivable should have turnover rates of at least 10:1; ideally 12:1.   These higher turnover rates indicate the ability to turn certain current assets into cash thus increasing the ability to meet payment deadlines for accounts payable.   If the reader is unfamiliar with these ratios, please read the following for a clearer understanding.

The key to evaluating short-term financial health is to focus on the trend and not a single moment i time when looking at current assets and current liabilities.   In general the working capital position should be constantly improving.

Summary

The ease of ability to manipulate the current ratio makes this tool an inappropriate mechanism to evaluate small business short-term financial health.   The basic formula is:

.     Current Ratio = Current Assets      .
.                               Current Liabilities

There are multiple drawbacks for its use in small business including economy of scale, significant impact of any 1:1 relationship (increasing liabilities and assets at the same time) with both sides of the equation.   Finally the disproportionately lower cash position of small business in comparison to larger operations produces misleading results.   All of these drawbacks increase the volatility of the current ratio’s us in small business.

Alternative methods include the net current assets trend line over more than 60 days; cash ratio and the quick ratio.   These tools provide more reliable indications of short-term financial health for small business.   Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.

If you found this article helpful, please consider a donation to the site.  The donation button is just to the right.  Even if you don’t make a contribution, I encourage you to read more articles on the website to help you become a better business entrepreneur.

About David J Hoare 429 Articles

I spent 12 Years as a Certified Public Accountant,
Over 20 Years of Practice in Accounting and Consulting,
Controller in Management of Closely Held Operations,
Masters of Science in Accounting,
Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns