Solvency or
liquidity ratios
Solvency
ratios (sometimes called liquidity ratios) indicate
how well your business can pay its bills in the
short term without straining cash flows. As you can
well imagine, your lenders are usually quite
interested in the shortterm solvency of your
business. (They want to make sure they get their
money back!) Some commonly calculated solvency
ratios are
Current ratio and
Total debt ratio.
Current ratio
The
current ratio is one of the best measures of whether
you have enough resources to pay your bills in the
next twelve months. It is calculated as
Current ratio =
Current assets/Current liabilities
The
current ratio can be expressed in either dollar
figures or times covered. For example, a business
has total current assets of $4,325 and current
liabilities of $3, 912. The business's current ratio
would be
Current ratio =
Current assets/Current liabilities
= $4,325/$3,912 =
1.11 : 1
In
other words, for every dollar in current
liabilities, there is $1.11 in current assets. You
could also say that the business has its current
liabilities covered 1.11 times over. For a refresher
on current assets and current liabilities.
To
a lender, the higher the ratio, the more secure is
their investment in your business. The same is
generally true for you as the business manager; you
want the ratio to be at least one or greater.
However, if your current ratio is higher than normal
for your business, it may indicate that you are not
using your resources effectively. This might happen
because you have one (or all) of the following
situations:

Abnormally high
inventory levels (i.e., you are overstocking
the pantry)

Surplus cash
sitting in the bank that should be invested long
term (or used to pay down current liabilities)

An accounts
receivable collection problem