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     Solvency or Liquidity Ratios - Current Ratio

 
 

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 short-term 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 over-stocking 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

 
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