With any business, especially during challenging economic times, it is important to understand what the current ratio is and how to use it. The current ratio is considered a liquidity ratio which measures a company’s ability to pay short-term loans. The formula for this liquidity ratio is: current assets over current liabilities. The result of this ratio is important because it tells you if you have enough cash, receivables and/or inventory to pay your short term debt. A result of 1:1 is okay, which means you have one dollar of current assets for each dollar of current liabilities. However, a good result would be 2:1 or better (a “good” result is different for every industry).

The higher the current ratio of the company, the better equipped they are at paying their vendors and any short term loans. If their current ratio is low it signifies to a bank, lender or vendor that the company has a lot of debt, but not necessarily that the company is going bankrupt. As there are many different ways to access financing so a low current ratio does not mean that a company will be unable to pay back their loans if they suddenly become due.

Current ratio is very similar to acid-test ratio, however, acid-test ratio does not include inventory. The acid-test ratio is much more focused on the ability to pay debt immediately with liquid cash or cash equivalents. The result of the acid-test ratio is the amount of liquid assets, that if sold, a company could use to pay its short-term debt on short notice.

So, what do you do with this information? That depends on why you are measuring your financial data. Maybe you are approaching a vendor for credit terms with their company. They may want to see your acid-test and current ratio results. If you are seeking a loan from a bank they will most definitely want to know the results of these two ratios. Maybe you are considering a marketing campaign or creating a new product line. Do you have enough cash or cash equivalents to be able to fund these efforts? Or you are operating on a very tight cash budget? If so, these ratios will give you a picture of where you stand at any given point in time.

Keep in mind that every company and business is unique and operates differently than another, so you need to locate the industry average that is most applicable to your business for a comparison point. If you can locate the ratio results of your competitors that is even better information. Even so, how you use this information is more important than how you compare to others in your same line of business.