If you are like most business owners, your company’s balance sheet is the least used and least understood financial statement. Yet, it is probably the most important financial statement.
Over the next few weeks I’ll do a deep dive into each of the critical balance sheet ratios. You’ll understand their meaning and can make sure that your trends are headed in the right direction. You’ll be able to spot minor issues and resolve them before they become major crises.
Current ratio is the first balance sheet ratio to pay attention to. It is critical because increasing current ratio means increasing ability to pay your bills and increasing profitability, most of the time.
Decreasing current ratio means that your profitability is decreasing and your ability to pay your bills is decreasing, most of the time.
When these trends are because of purchasing assets for cash, paying a huge tax bill, loans (such as the PPP loan that many companies received during the pandemic), or other huge cash increases or decreases not dependent on your day to day business operations, the trends do not follow the same rules as above.
Current ratio is defined as current assets divided by current liabilities.
Current assets are either cash or things that can be turned into cash within a year. The major categories of current assets are cash, investments, accounts receivable, inventory and prepaid expenses. Occasionally you’ll have some other current assets.
However, on an operational or day-to-day basis, you’ll generally have these categories.
Current liabilities are debts that must be paid within one year. The major categories of current liabilities are accounts payable, accrued taxes (payroll taxes, income taxes, state taxes, local taxes, etc.), deferred income, warranty, and current portion of long-term debt.
An individual month’s ratio tells you almost nothing. Graph your current ratio trends using trailing data (a year’s worth of data taken a month at a time). For example, the current ratio for April 2025 is the addition of the current ratios from May, 2024 through April 2025 divided by 12). It is the trend that matters. Is the ratio increasing or decreasing? And why?
Your trailing current ratio graph should look like the graph above.
If your company’s trend is not flat or increasing, find out why and resolve the issue.
You can spend the hours to calculate the ratios and graph them yourself or you can have software calculate the ratios and graphs for you in less than 10 minutes a month.
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