Current ratio – an introduction
Current ratio is a financial metric used to measure a company's ability to meet its short-term liabilities. This ratio is a critical tool for evaluating the liquidity of an e-commerce business (and those in other industries) and is used by investors and lenders to assess a company's financial stability.
What is the current ratio?
The current ratio is calculated by dividing a company's current assets by its current liabilities. Current assets include cash and other assets that can be converted into cash within one year. Current liabilities are the obligations due within one year.
Why is current ratio so important?
This metric is important because it provides insight into a company's ability to pay its short-term debts. A high current ratio indicates that the company has sufficient assets to pay off its debts, while a low current ratio suggests the company may struggle to meet its liabilities.
This information is critical for investors and lenders, as they want to be sure that the company they’re looking to invest in, or lend to, has the ability to repay its debts. It’s also important for decision-makers in the business to better understand how they’re managing working capital.
The current ratio can be used in conjunction with other metrics, such as burn rate/cash runway.
What’s a good current ratio?
The ideal current ratio for a company depends on several factors including the industry it operates in, its size, and the nature of its operations.
For example, a company in the retail industry may have a higher current ratio than a tech company, as retailers typically hold more inventory and other current assets that can be quickly converted into cash.
On the other hand, a tech company may have a lower current ratio due to its reliance on intangible assets, such as patents and intellectual property, which are not included in current assets.
In general, industries with stable and predictable cash flows, such as utilities or consumer goods, tend to have higher current ratios. Conversely, industries with high levels of volatility, such as technology, may have lower current ratios.
A current ratio less than 1 suggests that the company may not have enough cash or other current assets to cover its current liabilities. This could result in a negative impact on its credit rating, ability to access funding, or overall financial stability. In such cases, the company may need to take steps to improve its current ratio, such as reducing its liabilities, increasing its current assets, or a combination of both. For many businesses, this could mean raising funds through an equity raise. With a poor current ratio, closer cash flow management will be needed.
It's important to note that a current ratio less than 1 doesn't always mean that a company is in financial trouble, as there may be other factors that contribute to its financial stability. However, it’s considered a warning sign and should be evaluated carefully.
What does current ratio look like?
How do you calculate current ratio?
The formula to calculate current ratio is:
Current ratio = Current assets / Current liabilities
The result can be expressed as a value, or is sometimes expressed as a ratio such as:
Current assets : Current liabilities
Current ratio worked example
In this example, let’s assume an e-commerce business has the following balance sheet:
- Cash: £50,000
- Inventory: £150,000
- Trade debtors: £30,000
- Other debtors: £10,000
- Fixed Assets: £60,000
- Investments: £10,000
- Trade creditors: £75,000
- Credit cards: £15,000
- PAYE/NI payable: £60,000
- Bank loans > 2 years: £150,000
Of the information given, fixed assets, investments and bank loans > 2 years are ignored, as these are not current items. The current ratio would be calculated as:
Current ratio = (50,000 + 150,000 + 30,000 + 10,000) / (75,000 + 15,000 + 60,000) = 240,000 / 150,000 = 1.6
Current ratio = 1.6:1
The current ratio is a crucial metric for e-commerce businesses, as it provides valuable insight into the company's ability to meet its short-term liabilities. A high current ratio is generally a positive indicator of financial stability, although a current ratio that’s too high, can indicate you’re not maximising the use of your assets to grow. A low current ratio may indicate potential financial problems. As an e-commerce business owner, it’s important to understand the current ratio and keep it at a healthy level to enable financial stability and attract investors and lenders.