Using the Current Ratio
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One of the most important measures to consider is whether or not the business can pay debts to remain in operation. Accounting formulas and accounting ratios can quickly assess a company's short-term financial strength. This is especially important since the profits of the business do not accurately reflect cash on hand.
Under the accrual accounting method, the revenue is recognized when earned, whether or not cash is received as payment. Since sales may be on credit, even profitable companies may be at risk due to too much debt or a shortage of liquid assets.
Therefore, applying accounting ratios to the balance sheet offers a quick way to assess the actual short-term liquidity and strength of the business.
Definition of Accounting Current Ratio
| Current Assets/Current Liabilities |
This accounting ratio measures the ability of a company to pay its debts over the next 12 months. The general rule is a company should have more than twice the assets to pay debt obligations, or a ratio equal or greater than two. Anything below one is an indication that the company may not be able to meet its short-term financial obligations.
Because short - term assets can be quickly turned into cash, it is also a measure of market liquidity. Ratios that are too high may indicate that assets are not being utilized efficiently. This is not as concerning as a low ratio, but may affect long-term growth.
As with all accounting formulas and ratios, each should be compared to the relative industry and competition. Often each industry has its own standard for acceptable amounts. For example, luxury items may need a higher ratio during economic downturns since consumers are less likely to purchase luxury items when budgets are tight.
The below table show the ratios for the software industry, Sunny Sunglasses Shop's main competitor, Luxottica Group, the industry average (Specialty Retail, Other), and well as the S&P 500.
Current ratio analysis
| Company | Current Ratio |
| Software Industry | 1.9 |
| Microsoft | 1.7 |
| Specialty Retail, Other | 1.4 |
| Sunglasses Hut Int. (Luxottica Group) | 1.0 |
| S&P 500 | .9 |
Industry averages can be found at MSN Money under Financial Results: Key Ratios, and Yahoo Finance under Company: Competitors.
To view the balance sheet example for Sunny Sunglasses for a comparison of these accounting ratios, click examples of balance sheets.
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