What is A Current Ratio and Why Does It Matter?
Running out of cash can be a frightening experience. It is one thing when you are in a restaurant, and you 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 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 liquidity has become even more apparent during the pandemic. High job losses, business closures, and medical needs have put financial strains on many of us.
Finding financial happiness is more than just making money. To achieve your short-term and longer-term financial goals, you need to know and understand your financial position. Preparing financial statements, as businesses do, 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 you 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 less total liabilities, or what you owe. Hopefully, what you own is more than what you owe. Using data from your net worth, you can analyze many different key 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 and give 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 that 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 your future needs, whether running out of cash or even 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. Having financial flexibility allows you to react to and adapt to changing financial conditions like a recession and losing your livelihood.
What Is The 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 seeking 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 your short-term debts.
Evaluating 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 strong 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.
- 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 the ability to convert 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 the liquidity of businesses as opposed to households. 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
Before we had kids, we enjoyed collecting art and antiques. 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 well below the price we paid and learned a valuable lesson. Asset categories matter.
A current ratio measures the household’s ability to liquidate those assets to meet their short-term obligations without additional borrowing. Although there may be differences in 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 other 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 able to quickly convert into cash with minimal loss in value. You can sell your car but at a depreciated rate and potentially below its fair market value depending on condition, mileage, and use. 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 $3,000
- Marketable Securities (eg. stocks, bonds) $45,000, includes $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.
Notice that 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 to opportunity for the securities to bounce back.
Use Caution When Determining Your Current Assets
As a long-term investor, I have experienced declining stock values in my portfolio many times. A range of factors causes market turbulence, such as an unstable economy. Although tempting, it may not be wise to sell your marketable securities like stocks and bonds. 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.
Don’t rely on your investments as current assets if you have a long term perspective. It would be best if you considered a small portion, say 5%-10% of your investment accounts as cash in the short term.
Don’t Count On Retirement Or College Savings
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 you are saving for your retirement through your company-sponsored 401K and IRA plans. These accounts are the last places you should withdraw money and should not be considered liquid assets. They provide tax-deferred benefits as well as compounding growth as long as you leave the money in place.
Besides, withdrawing money from these funds usually causes potential tax liabilities and penalties on these 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 do include existing business assets, make sure to add your business’s current liabilities as well.
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 having financial flexibility. It can mean the difference between 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, associated with a flexible loan that you may access as needed and repay immediately or over time with interest. $1,000
- Auto loans or leases due $5,400
- Student loans $4,500
- A mortgage loan, maintenance, or rent payments due $12,000
- House Equity Line of Credit (HELOC) if you borrowed money., unused.
- Installment Loans for household appliances, electronics, furniture $1,000
- 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 the high-interest rates charged by credit card issuers. A year from now, that amount will increase to $7,000 (assuming no other borrowing on your card), possibly outpacing current asset growth, bringing your current ratio down.
Limitations Of The Current Ratio
Be honest about what you include for 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 that means current assets will go down from using your cash.
While “cash is king,” too much cash may mean you need to 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 next 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.
Strategies To Increase Your Current Ratio And Overall Financial Position
To improve your current asset position relative to liabilities, evaluate your spending habits. Overspending or impulse buying can lead us to buy things we can’t afford or need.
For example, when we are looking at our favorite sites, we come across a beautiful coat. 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 is a bias that stimulates our need for immediate gratification at the expense of our need to save. Rather than saving, we will be increasing the balance on our credit card. When we shop, we are often subject to marketers exploiting our biases, as we discuss here.
Track Your Spending
If you are susceptible to overspending or spending money you don’t have, try tracking 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 obvious costs. You may be binge-watching more than ever as you sign up for all the new streaming options. Last year, I found that Craig had downloaded hundreds of dollars worth of Kindle books over two weeks. I was surprised, but when I brought it to his attention, he was even more shocked.
Due to the pandemic, we have spent less on entertainment, vacations, and other typical places before social distancing. As a result, we may have even picked up some good habits like cooking more, engaging in DIY projects, and even doing without some luxuries. We all want to get back to our everyday lives, see friends and family, but that shouldn’t mean losing any financial discipline we gained.
Consider your financial goals when accumulating assets. Be mindful of their potential appreciation value and the respective market. Our arts, rare books, and antiques served their purpose for many years. However, we took a significant loss when we transitioned to a different lifestyle and a growing family. Falling in love with the art on the wall and the furniture are nice but were not suitable investments.
Many people are struggling due to the coronavirus-related economic downturn. You may have lost your job, had your hours reduced, or want to boost your income. Think about what solutions suit you best.
If you like your firm and want to advance there, consider expanding your skills and knowledge. Talk to your boss about ways you to increase your training to be helpful to your department. Even if you are delighted with your current situation, always consider ways to invest in yourself throughout your career.
Many people worked remotely due to social distancing. You may want to continue to do so as a work/life balance or cost-savings measure and be ready to do it long term. Another way to earn more is to take on a part-time job or do some freelancing. Consider options that fit with your current family lifestyle and can be financially beneficial.
Allocate Some Savings To Investments
Even if you only have a small amount of savings, begin to invest as early as you can. However, before taking that step, make sure you have first 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 big weight on your current ratio and hard to manage when you pay on average 16% APR. Your debt may continue to grow faster than your current assets. This is an untenable situation. Eventually, it will difficult to find liquidity when you need to.
Don’t buy a bigger home than you can afford or need. Consider a shorter mortgage, such as 15 years, to pay less total interest on the price of your home. Yes, your monthly mortgage will be bigger, but for a shorter time and less cumulative interest. Refinance your mortgage if you are paying a higher mortgage rate than currently offered.
Using financial benchmarks, notably the current ratio, are useful as a starting point to 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 financially comfortable or strained. Preparedness and financial discipline are essential for you and your family.
This article originally appeared on Your Money Geek and has been republished with permission.