What Is a Good Current Ratio?
A good current ratio is ≥1. A current ratio of 2 and above is ideal and can attract many lenders. However, the answer to what is a good current ratio tricles down to your industry.
When your business’s current ratio is 1, you have 1 dollar of current assets to liquidate and pay for 1 dollar of current liabilities. In other words, your business’s current assets equal your current liabilities.
When you have a current asset of anything above 1, say 1.5, your business has 1.5 times more current assets than current liabilities. You can thus pay off all your current liabilities and remain with 0.5 times your current assets.
If you manage your business so well that its current asset ratio is 2 and beyond, you have no cause for concern. Your business is financially strong, and if you continue this way, it is headed for growth.
Because the current ratio varies in different industries, some generally have low current ratios and others high. You could be operating in an industry where a current ratio of 1.5 is considered high. Similarly, your business could be in an industry with an extremely high current ratio to the extent that 1.5 is on the lower end.
Always try to analyze your industry’s current ratio average. Compare the health of your current ratio with this average. Try to find out whether creditors accept financing businesses with a current ratio lower than 1 in your industry. It happens in some industries and businesses still make profits.
1. Useful to creditors
It is rare to find a business operating without some form of external funding. This universally applies to both small and large businesses. Creditors have always existed as enablers of business funding. Loans from creditors have been an enabler of success for many businesses.
However, being in business does not imply you will qualify for a loan from any lender. Your business has to prove its worth to receive external financing. The way to prove your business is worth funding by a lender is through its current ratio.
Creditors use the current assets ratio to quantify the capacity of your business to pay off the loan under consideration. By checking the current ratio, they can tell whether your business can pay debts by liquidating its current assets or will be forced to take a loan elsewhere to pay this lender.
Lenders want to finance those businesses that can settle loan balance by liquidating their current assets. They are not interested in funding your business if your resort to other loans to pay for a loan. To lenders, they would wish to start a long-term financial relationship with your business. Establishing such a relationship on a poor current ratio is a barricade to such a long-term financial relationship.
2. Signals ability to liquidate current assets and pay off liabilities
As a business owner, you try to protect your brainchild from going under as much as possible. You want to protect your business from insolvency. In most cases, you are even looking for what can make things go wrong and drown your business in debt.
The best approach you need to be using to ascertain how good is your business’s financial health is the current ratio. A good current ratio signals that you are in a healthy position to liquidate your current assets and pay your creditors.
Paying creditors on time from your business’s current assets improves your chances of getting more funding. The higher funding, in this case, emanates from the confidence that creditors have in your venture. From a professional’s point of view, they can tell you are doing the right thing.
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As a business owner, it gives peace of mind in your industry of operation. You are not constantly worrying about where to get a loan to pay for other loans. You know your business is growing and strengthening its financial muscles to pay creditors on or before due.
3. It warns you of potential financial difficulties
Your business could have experienced a challenging past. It could be a past where the entire industry was slowly growing, or forces beyond your control hit it. As a business owner, your brainchild has to remain afloat. You need to predict possible financial challenges and proactively adjust financial management.
A poor current ratio (compared with the industry average) will signal your business’s likelihood of being insolvent. It could signal a future where you lose your business and its assets. Reading between the lines of your business’s current ratio helps you adjust accordingly for your venture to thrive in challenging economic times.