What Is A Current Ratio And Why It Matters

Running out of cash can be a frightening experience. It is one thing when you’re in a restaurant and leave your wallet at home. However, it can be quite stressful to realize you have a potential cash flow problem coming down the pike.

By exercising financial discipline, you can avoid some everyday stresses. Having a large emergency savings fund when unforeseen events happen can soften the blow of sudden but necessary expenses. And yet, many Americans have not put enough savings aside for life’s uncertainties. Having enough liquidity has become even more apparent as prospects for a recession increase. High job losses, business closures, and medical needs have strained many of us financially.

Finding financial happiness is more than just making money. You need to know and understand your financial position to achieve your short-term and longer-term financial goals. As businesses do, preparing financial statements will help you evaluate strengths and weaknesses.

Think of your family household as a business. The family balance sheet is your net worth statement, providing a snapshot of your financial condition. To avoid liquidity problems in good or bad times, the current ratio is among the best ways to measure your family’s ability to pay debt obligations within a year.

Personal Net Worth As A Key Benchmark

Net worth is a great way to review your personal financial data accounts at a point in time. It is calculated using your total assets: what you own minus total liabilities or what you owe. Hopefully, what you own is over what you owe.

Using data from your net worth, you can analyze critical personal financial ratios to develop better habits. We have written about various financial benchmarks in money management: savings, retirement, spending, investing, debt accumulation, and reduction. These ratios can be easily calculated, giving you a better sense of your financial health and progress relative to your goals.

Liquid Net Worth As A More Realistic View

Liquid net worth is an even better and more realistic benchmark because it focuses on your assets’ liquid nature. That means those assets can be quickly converted into cash with little or no loss of value. Although net worth remains a helpful gauge, it doesn’t differentiate your assets from their liquidating value.

As such, liquid net worth gives you a better understanding of your assets and future needs, whether you are running out of cash or exploring an opportunity. Drilling further down, the current ratio is among the best financial ratios. This ratio is easy to calculate and measures your liquidity position. Financial flexibility allows you to react to and adapt to changing financial conditions like a recession and losing your livelihood.

What Is A Current Ratio?

What is a current ratio? When measuring your current ratio, your focus is on existing assets. You can convert into cash within a year and current liabilities due within the year. The current ratio is sometimes referred to as the working capital ratio. Businesses, analysts, and investors have used these formulas to seek strong balance sheets that predict which companies can best pay their short-term debt obligations. Similarly, a family household can use the ratio to know whether they can rely on having enough short-term assets readily available to pay their short-term debts.

How To Evaluate Your Current Ratio

This ratio is essential to avoid money shortfalls but may highlight your liquid position to maximize your business growth or family wealth. Investors use the current formula to search for companies with solid balance sheets to weather economic downturns. Lenders review your financial statements, crunching numbers to judge their risk exposure by your ability to pay your loans. Financial advisors use your data to help you develop your goals and strategies to achieve your financial plan.

Our Focus

• Define and calculate the current ratio.
• Understand the ratio and its limitations.
• Strategies to improve our financial position.

The Current Ratio Definition

The current ratio relates current assets to current liabilities and is easy to calculate. It helps you to understand your liquidity position within the short-term period of one year. Liquidity refers to converting your assets into cash with little or no loss of value. The quick ratio is a close cousin to the current ratio but uses a shorter time frame of 90 days or less and uses receivables. As such, the quick ratio is more attuned to businesses’ liquidity than households. Small businesses should use the current ratio for their business, though industries vary.

Certain assets, particularly financial assets, tend to be easier to convert as marketable securities with values. What other holdings can you sell quickly to convert into cash?

Not All Assets Are Equal

We collected art and antiques for years for enjoyment rather than investment returns. We happened to make these purchases at the peak of that market. Once we had kids, our tastes dramatically changed. So did the art and antique market, which collapsed around the Great Recession. Try selling those items in a hurry! We sold many pieces at a fraction of the price and learned a valuable lesson—asset categories matter. Households need some liquid assets. A current ratio measures the household’s ability to liquidate those assets to meet short-term obligations without additional borrowing.

Although there may be differences in the assets and liabilities of a household or business, the calculation is pretty much the same. Cash inflows and cash outflows are often a trade-off between having liquidity and using your surplus cash for growth.

Current Ratio Formula = Short-term Assets/Short-Term Liabilities.

Current liabilities reflect the debt payments owed in the current year. That would be your monthly credit card balances and debt payments owed that year. A ratio of one or higher indicates you have more short-term assets than debt, a sign of good financial health.

Current Assets In The Household Balance Sheet

Your family may own various assets, ranging from monetary assets (or financial and more liquid assets), tangible assets (e.g., cars, houses, or furniture), and diverse investment assets. The current ratio relies on liquid assets that are able to convert quickly into cash with minimal loss in value. Depending on the condition, mileage, mileage, and use, you can sell your car at a depreciated rate and potentially below its fair market value.

A typical example of current assets your family household may have:

• Cash On Hand $500
• Savings Accounts $1,500
• Emergency Savings Account $1,200
• Checking Accounts $1000
• Tax Refund Due $400
• Money Market Accounts for $3,000
• Marketable Securities (e.g., stocks, bonds) $45,000, including $4,500* in cash
• CDs $1,000
• Cash Value of Life Insurance Policies $15,000
• *Cash portion only.
• Total Current Assets $28,100

Summing up the amounts of $500 +$1,500 +$1,200 + $1,000 + $400 + $3,000 + $4,500 + $1,000 + $15,000 equals $28,100 in total current assets.

I only added 10% of the marketable securities, or $4,500. You don’t want to inflate current assets. It is best not to count on your investments. Instead, add only the cash portion. Markets can be volatile, often impacting values in the short term, but you want the opportunity for the securities to bounce back.

Use Caution When Determining Your Current Assets

As a long-term investor, I have often experienced declining stock values in my portfolio. A range of factors causes market turbulence, such as an unstable economy. Although tempting, selling marketable securities like stocks and bonds may not be wise when they are down.

As we saw with the pandemic in the spring of 2020, stocks tumbled but returned reasonably quickly to acceptable values. Panicking is never a good time to sell stocks in a plummeting stock market, only to sell some of your winners. If you have a long-term perspective, don’t rely on your investments as current assets. It would be best to consider a small portion, say 5%-10% of your investment accounts, as cash in the short term.

Don’t Count On Retirement Or College Savings For Liquidity

Retirement or college savings accounts are long-term assets designed for your financial future. When you set up 529 College Savings accounts for your children, you build a fund for tuition and other costs. Likewise, when saving for retirement through your company-sponsored 401 (k) and Roth IRA plans, although PLESA accounts may be helpful in a pinch.

These accounts are the last places you should withdraw money and should not be considered liquid assets. They provide tax-deferred benefits and compounding growth if you leave the money in place. Besides, withdrawing money from these funds usually causes potential tax liabilities and penalties for long-term assets. Generally, this is usually a costly move. It is better to look elsewhere first for cash.

Some families have side hustles or start-up businesses, which may add some current assets such as customer accounts receivables, inventories, prepaid expenses, and notes receivable expected within the year. If you include existing business assets, add your business’s current liabilities.

Current Liabilities In The Household Balance Sheet

This category is for current obligations that you owe within the current year. Managing your debt is critical to a good current ratio and financial flexibility. It can mean financial success or strain for you and your family. Typical accounts that are due within the year:

Outstanding credit card balances of $6,000

Line of credit balances is associated with a flexible loan you may access as needed and repay immediately or over time with interest. $1,000

Auto loans or leases due $5,400

Student loans of $4,500

A mortgage loan, maintenance, or rent payments owing $12,000

House Equity Line of Credit (HELOC) if you borrowed money., unused.

Installment Loans for household appliances, electronics, and furniture of $1,000

Are any other short-term loans coming due?

Total Current Liabilities $28,900

Total current liabilities are the sum of the amounts of $6,000 +$5,400 +$4,500+ $12,000 + $1,000= $28,900

What A Current Ratio Reveals

To calculate your current ratio, you divide total current assets by total current liabilities. Looking at the current ratio, we divide $28,100 by $28,900, equaling a current ratio of 0.97, very close to 1.0.

A score of 1 means that your current assets match your current liabilities. However, you may want to target a more desirable rate of 2, indicating better asset coverage of the household’s debt obligations due within a year. A 2 current ratio means for every dollar of liability. You have $2 in existing assets.

What stands out in current liabilities is $6,000 in outstanding credit card balances weighing on current liabilities. This amount grows faster, given credit card issuers’ high interest rates. A year from now, that amount will increase to $7,000 (assuming no other borrowing on your card), possibly outpacing current asset growth and bringing your current ratio down.

Limitations Of The Current Ratio

Be honest about what you include in this analysis. Don’t inflate your current assets or understate your current liabilities. Consider any trade-offs like paying off fast-growing card balances, even if current assets will decrease from using your cash. While “cash is king,” too much cash may mean you must allocate more to growing your retirement or investment assets.

That can mean an opportunity cost to you and your family by not maximizing your wealth-generation potential. The opportunity cost of any decision is the cost of the following best alternative that must be foregone. Keeping cash in your savings account instead of a retirement amount shortchanges your nest egg in the long run.

How To Increase Your Current Ratio And Overall Financial Position

Spend Less

Evaluate your spending patterns to improve your current asset position relative to liabilities. Overspending or impulse buying can lead us to buy things we can’t afford or need. For example, we see a beautiful coat at our favorite sites. We don’t look away even though it is out of our price range, and we just bought a lovely coat a few weeks ago. Present bias stimulates our need for immediate gratification at the expense of our need to save. Rather than saving, we will increase the balance on our credit cards. As discussed here, we are often subject to marketers exploiting our biases when we shop.

Track Your Spending

If you are susceptible to overspending, track your monthly bills. You may be surprised at how many things you thought you needed but haven’t even used. Return those items or learn how to control your spending better. Review your budget for places where you may reduce some apparent costs. You may binge-watch more than ever as you sign up for all the new streaming options.

Consider your financial goals when accumulating assets. Be mindful of their potential appreciation value and the respective market.

Boost Income

Many people struggle during economic downturns, losing their jobs or reduced hours. Consider expanding your skills and finding a side gig to help you earn extra money.

Even if you’re delighted with your current situation, always consider ways to invest in yourself throughout your career. Many people work remotely and find more flexibility in a part-time job, longer hours, or turning a hobby into a side hustle.

Allocate Some Savings To Investments

Save more, and begin investing as early as possible. However, before taking that step, ensure you have set aside an emergency fund for unforeseen events. When you are young, you have a long-term horizon that allows you to take on more risk and handle the volatility.

Manage Your Debt Properly

Pay your credit card balances on time and in full so your debt doesn’t grow on a compound basis. Carrying card balances is a significant weight on your current ratio and hard to manage when you pay, on average, over 20% APR. Your debt may continue to grow faster than your current assets. This is an untenable situation. Eventually, it will be challenging to find liquidity when you need to.

Mortgages remain high but are expected to come down over the next year. Don’t buy a bigger home than you can afford or need.  If you can afford the monthly payment, consider a 15-year fixed mortgage to pay less total interest on the price of your home. Yes, your monthly mortgage will be more significant for a shorter time and with less cumulative interest.

Final Thoughts

Using financial benchmarks like the current ratio is helpful as a starting point for understanding your financial health. Evaluating your financial strength and position can move you towards meeting your goals and achieving success. Having sufficient liquidity to deal with potential struggles in the future may be the difference between being financially comfortable or strained. Preparedness and financial discipline are essential for you and your family.

Thank you for reading this article! Please visit us at The Cents of Money for more articles of interest.