Liquidity is the ability of a business to utilize its short term assets (cash, accounts receivable and inventories) to meet its short term liabilities as they fall due.
The financial projections template uses the current ratio as an indicator of the liquidity of the business.
Current Ratio Formula
The current ratio formula is the current assets divided by the current liabilities of the business.
Both of these values are found on the balance sheet of the business.
If the current ratio is greater than one it shows that current assets are larger than current liabilities and indicates that the business should be able to convert its short term assets (cash, inventory, accounts receivable) into cash and pay its short term liabilities (accounts payable).
On the other hand, if the current ratio is less than one, the current assets are less than the current liabilities, and the business may be in danger of not being able to satisfy its short term liabilities as they fall due.
Ideally the current ratio should be greater than one and, to provide a margin of safety, should be in the region of two.
Current Ratio Example
The balance sheet below is used as an example to show how to calculate the current ratio
|Property, plant and equipment||500|
|Total liabilities and equity||1,180|
The numbers used in the calculation of the current ratio are highlighted in the balance sheet shown. In the above example the current assets are 680 and the current liabilities are 425.
Using the current ratio equation the ratio is calculated as follows:
Current ratio = Current assets / Current liabilities Current ratio = 680 / 425 Current ratio = 1.6
In this case a ratio of 1.6 indicates that the current assets are 1.6 times greater than the current liabilities, and that the business should be able to pay its short term liabilities as they fall due.
The current ratio is reported on the ratios page of the financial projections template and should be monitored to ensure that it shows a value which is improving over time and is at least equal to one.
The current ratio will vary from industry to industry, and therefore it is important when making comparisons to determine an industry current ratio based on financial statements of businesses similar to your own.
While an increasing current ratio can indicate increasing liquidity, a ratio which is too high implies a lot of funds are tied up in accounts receivables, inventories or as cash. It is generally accepted that funds tied up in this way earn very little or nothing for the business.
The current ratio is one of many financial ratio formulas used to analyse accounting financial statements.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.