21. Ratios: Current Ratio

Let's take a look at the current ratio. Right off the bat, ratio. Ratio means something to something else or something over something else, right? This is old school algebra, real basic stuff. But as a way of remembering, whenever you see current ratio, you should be thinking, okay, well, I need a ratio of x to y or a fraction of x over y. So let's look and see what that fraction actually is. The current ratio is just current assets to current liabilities, which is current assets over current liabilities equals current ratio. So again, it's all right there in the name. You're looking for the current ratio, so you need current to current, and it's just assets to liabilities.

So what's the purpose of the current ratio? Because we already know we can figure out working capital. We can figure out working capital by taking current assets, subtracting current liabilities, and we get working capital. So we know how much in working capital we have. So why are we doing this ratio? Why does that matter? Well, working capital is good, except it doesn't give you any point of reference, really. So let's go down here, and just as an aside, let's say working capital equals $50,000.

Is $50,000 in working capital good, or is it bad? Well, that's really hard to answer, because in a business like mine, where I make accounting videos, $50,000 in working capital is crazy. But in a business like Ford's, where they make cars, $50,000 is nothing at all. So this number lacks context. It's a good number to know, but it's not that great, because it lacks context. Now, what the current ratio gives you is a little bit more context. So let's say you have $100,000 in assets and $80,000 in liabilities. Then your current ratio would be 1.25.

So that means for every liability, we can go up here, for every liability that you have, you have 1.25 assets. So that comes out to be $1.25 in assets for every dollar in liabilities, right? Now, we can take this number and compare it to some industry standards to see if 1.25 is good or 1.25 is bad as a ratio for our industry or our type of business. Now, as a rule of thumb, if you see a current ratio of 2, so for every $1 in liabilities, you have $2 in assets, that's generally a sign of a healthy short-term financial position. That doesn't necessarily mean that less than 2 is bad, and that doesn't always mean that 2 is good.

But this is just a general rule of thumb that a 2 to 1 asset to liability ratio is generally pretty good.