The Current Ratio: What Is It & Why Is It Important?
In short, the current ratio is one metric often used by lenders to calculate a small business loan applicant’s ability to meet its current, short-term obligations.
How Do I Calculate the Current Ratio?
Current Ratio = Total Current Business Assets divided by Total Current Business Liabilities.
- Examples of Current Assets: Cash, Accounts Receivable, Inventory.
- Examples of Current Liabilities: Accounts Payable, Accrued Payroll & Other Expenses, Line of Credit Balances and Credit Card balances.
In essence, the current ratio represents the relative position between a borrower’s liquid assets and near-term expenses/liabilities.
Why Is the Current Ratio Important To Lenders?
The Current Ratio is a measure of a company's liquidity and its short-term financial health. If a company has a Current Ratio of greater than 1.00, then it should have the ability to cover all of its near-term liabilities and continue to invest and grow. If a company's current assets do not exceed its current liabilities, that might indicate that the company does not have the resources to weather a short-term decrease in cash flow and may have trouble paying back creditors.
Lender's typically want to see that a borrower not only has the resources to repay its loan, but that it also has the ability cover all of its expenses and other liabilities. "Liquidity" is important because it generally serves as a backdrop for any short-term cash flow issues. If a borrower’s sales are down, or if it has any unforeseen expenses, the lender will want to see that it has the liquid assets to cover its bills until things get back on track.
How Could a Lender Help A Small Business Improve Its Current Ratio?
- Small Business Line of Credit – lines of credit often have lower interest rates than credit cards. If a small business owner were to use a line of credit instead of credit cards, that might help reduce interest expense, helping current liabilities go down over time.
- Working Capital Term Loan – a working capital term loan would result in a cash infusion and help increase a small business’s current assets.
- Debt Consolidation Term Loan – a debt consolidation loan might help a small business move some of its current liabilities to long-term liabilities. This often helps decrease near-term debt obligations and ease cash flow.
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