Determining the Short-Term Solvency of a Business
The current ratio is a test of a business’s short-term solvency — its capability to pay its liabilities that come due in the near future (up to one year). The ratio is a rough indicator of whether cash on hand plus the cash to be collected from accounts receivable and from selling inventory will be enough to pay off the liabilities that will come due in the next period.
As you can imagine, lenders are particularly keen on punching in the numbers to calculate the current ratio. Here’s how they do it:
Current assets ÷ Current liabilities = Current ratio
Unlike most other financial ratios, you don’t multiply the result of this equation by 100 and represent it as a percentage.
Businesses are generally expected to maintain a minimum 2 to 1 current ratio, which means its current assets should be twice its current liabilities. In fact, a business may be legally required to stay above a minimum current ratio as stipulated in its contracts with lenders.
The business in the figure below has $136,650,000 in current assets and $58,855,000 in current liabilities, so its current ratio is a favorable 2.3.