Experiences from an Entrepreneur

Here is a very common ratio that a small business can start using right away.

The Current Ratio is used by short-term creditors to determine a company’s ability to meet short-term financial obligations. Short-term creditors prefer a high Current Ratio. Higher current ratios are an indication of lower risk and consequently, lower current ratios suggest higher risk.

The current ratio is calculated by dividing current assets by current liabilities:
(If you don’t know what Assets or Liabilities are, Check this out).

Current Ratio: Current Assets
Current Liabilities

Here are two examples:

EXAMPLE 1
Current Assets: $250,000 (this includes cash, inventory, accounts receivables, etc.)
Current Liabilities: $75,000 (this includes financial obligations that will be paid within the year)

$250,000 / $75,000 = 3.33 (This situation is less risky for short-term creditors)

EXAMPLE 2
Current Assets: $100,000
Current Liabilities: $125,000

$100,000 / $125,000 = 0.80 (This situation is more risky for short-term creditors)

One reason that you need to understand about this ratio is that creditors prefer a higher current ratio because it reduces risk BUT owners tend to prefer a lower current ratio because this could be an indication that more of the firm’s assets are working to grow the business.