How to calculate the current ratio

The formula in words: total current assets divided by total current liabilities, both at the same balance sheet date. If current liabilities are nil there is nothing to divide by, so they must be above zero.

business.gov.au's glossary uses the same time limit on both sides. A current asset is cash or something expected to become cash within 12 months, and a current liability is one that must be paid within 12 months. It also says a balance sheet helps you work out business liquidity: how fast the business could settle its current debts. The current ratio is one way of putting a figure on that.

Bring the books up to the balance date first: reconcile the bank and card accounts, enter every invoice and bill dated on or before it, and update the stock figure. Then total each side.

• Current assets: cash at bank, petty cash, inventory and prepaid expenses, which are the items business.gov.au's balance sheet template lists, plus money customers owe you.
• Current liabilities: supplier bills, credit card balances, interest payable, wages owed to staff for work already done, any overdraft that is drawn, and the part of each loan that falls due within 12 months.

Equipment, vehicles and loan instalments due beyond the next 12 months are left out.

Total current assets grew over the year, but current liabilities grew faster, so the ratio fell. The mix moved too: cash dropped while money owed by customers rose. Both changes are worth a closer look before anyone acts on the latest figure.

The ratio tells you how many times over current assets would cover current liabilities if every current asset turned into cash. When current assets are the larger total, they would cover the bills due within a year more than once. When current liabilities are larger, current assets would cover only part of them.

There is no single figure that suits every business. A café with little stock and daily takings works very differently from a wholesaler carrying months of stock, so the most useful comparison is with your own business at earlier dates.

The total also hides what it is made of. business.gov.au defines liquidity as how quickly assets can be converted into cash. Stock has to be sold, and customer debts collected, before either can pay a bill. The quick ratio leaves out stock, prepayments and other less readily available current assets for a narrower view of the cover.

Most transactions that touch a current asset or a current liability move the ratio, and some move it in ways that surprise people. The table starts from one balance sheet and applies each transaction to it on its own, so each row can be compared with the starting point.

Work one row through to see the method. Buying equipment takes 6,000.00 out of the bank, so current assets fall from 30,000.00 to 24,000.00. Equipment isn't a current asset, and nothing is owed, so current liabilities stay at 20,000.00. Then 24,000.00 divided by 20,000.00 gives 1.20.

• Paying a current bill from cash shrinks both totals by the same amount. When current assets are the larger total, that lifts the ratio.
• Taking on a current liability to get a current asset, such as stock on credit or a short-term loan, grows both totals by the same amount. When current assets are the larger total, that lowers the ratio.
• Swapping one current asset for another, such as collecting a customer debt, leaves the ratio where it was.
• Spending current assets on something long term, such as equipment, lowers it. Long-term borrowing raises it, because the cash counts as current but the debt does not.
• Selling stock for more than it cost lifts the ratio, because the stock leaves at its cost and the amount the customer owes comes in at the selling price.

No. Both totals are made up of balances that are zero or more, so the ratio can go no lower than zero, which would mean the business had no current assets at all.

If your working ever gives a negative figure, a balance is sitting on the wrong side. A typical case is an overdrawn bank account entered as a negative current asset: if the overdraft is larger than everything else on that side, current assets come out below zero. An overdrawn account is money owed to the bank, so it belongs in current liabilities as a positive amount.

The same slip on a smaller scale doesn't turn the ratio negative, but it still gives the wrong answer. Say an account is 3,000.00 overdrawn and the other current assets total 18,000.00, against 12,000.00 of other current liabilities. Netted, the working shows 15,000.00 divided by 12,000.00, or 1.25. Correctly classified, it is 18,000.00 divided by 15,000.00, or 1.20.

A current ratio below 1 means current liabilities are the larger total, and the reasons show on the balance sheet itself. Look for:

• Long-term items paid for with short-term money, such as equipment bought from cash or on a credit card, which the table above shows lowering the ratio.
• A loan's final lump sum, which business.gov.au's glossary calls a balloon payment, falling due within the next 12 months. The whole amount moves into current liabilities, so the ratio can drop sharply in a month when nothing else changed.
• Losses draining cash over several months while the bills keep arriving.

A ratio below 1 doesn't by itself mean bills will go unpaid. Timing decides that. A business whose customers pay on the day, and whose suppliers allow 30 days, can have cash arriving faster than its bills fall due. One whose customers take 2 months to pay has far less room. The cash flow forecast, not the ratio, shows which of those describes your business.

It can be higher than the business needs, and a high figure is not automatically good news. Look at what is driving it before taking comfort from it:

• Stock building up. business.gov.au's cash flow guidance makes the point that cash spent on unsold stock is cash the business no longer has to use. Slow-selling stock lifts the ratio while tying up cash.
• Customers paying slowly. A growing pile of unpaid invoices adds to current assets, but none of it is in the bank yet.
• Cash with no job to do. A large balance may be exactly what you want before a quiet season or a planned purchase. If it isn't, business.gov.au's budget guidance lists paying off debt, saving for emergencies and growing the business as uses for extra money.

Treat a rise the way you would treat a fall: find the lines that moved, and ask whether the change is one you planned.

• Timing around the balance date: paying suppliers from cash the day before shrinks both totals and, when current assets are the larger total, lifts the ratio, although nothing about the business has improved.
• A loan recorded entirely as long-term even though instalments fall due within the year, which leaves current liabilities understated.
• Supplier bills that haven't been entered yet.
• Old customer debts counted at face value. Amounts that probably won't be collected for a long time are what business.gov.au calls bad debts, and how they are treated is a question for your accountant.
• An unused overdraft limit counted as cash. Only money actually held counts as cash.

Read the current ratio against your own business's history and against when its payments actually fall due, not against a single target figure. The comparisons that tell you most:

• The previous month end, so a change shows while it is still small.
• The same month last year. A business that builds up stock before its busy season will show a different ratio at that point every year, so compare like with like.
• The figure you expected. Before a large purchase or new borrowing, work out what the ratio would be afterwards, using the patterns in the table above, and check the actual result against it.
• The timing of payments. Put the month-by-month cash flow forecast beside the ratio: a comfortable figure can still hide a large bill due next month while most customer invoices aren't due for weeks.

Lenders set their own terms. business.gov.au notes that loans vary in their costs and conditions, and suggests reading each loan's terms and conditions carefully, including any restrictions or other conditions. If an agreement the business has signed refers to a figure from its balance sheet, the agreement's own wording is what counts, so ask your lender or your accountant what it means for the business.

Repeat the calculation at every month end using the same method, and line the results up so a slide shows early. Pair it with a cash flow forecast, which shows month by month whether income is likely to cover what falls due; business.gov.au describes forecasts as estimates of future sales and costs.

If the ratio is falling, find which lines moved before acting. business.gov.au's cash flow guidance suggests collecting money owed sooner, holding less stock and negotiating longer supplier terms, but these mainly help cash rather than the ratio: collecting a debt swaps one current asset for another, and paying suppliers later keeps both the cash and the bill on the balance sheet, which lowers the ratio whenever current assets are the larger total. Test any change in the cash flow forecast as well as against the ratio.

A spreadsheet makes the monthly calculation quick and keeps the history in one place. The layout below works in any spreadsheet program:

1. Put each current asset and each current liability on its own row, grouped under two headings, with one column for each balance sheet date.
2. Add a total row under each group.
3. Add a ratio row that divides the current assets total by the current liabilities total in the same column, rounded to two decimal places.
4. Make the ratio row show a short note instead of an error when current liabilities are nil.
5. Fill in a new column at each month end from the balance sheet report in your accounting software, once the bank accounts are reconciled.

Keep each month's balance sheet with the spreadsheet, so any ratio can be traced back to the figures it came from. A row of ratios across 12 or more month ends shows the seasonal pattern of your own business, which is the history every comparison above depends on.