# An overview of the role of current ratio figures in an organization

Common size ratios can be developed from both balance sheet and income statement items. The phrase "common size ratio" may be unfamiliar to you, but it is simple in concept and just as simple to create. You just calculate each line item on the statement as a percentage of the total.

For example, each of the items on the income statement would be calculated as a percentage of total sales. Divide each line item by total sales, then multiply each one by to turn it into a percentage.

Similarly, items on the balance sheet would be calculated as percentages of total assets or total liabilities plus owner's equity. This simple process converts numbers on your financial statements into information that you can use to make period-to-period and company-to-company comparisons.

Common size ratios make comparisons more meaningful; they provide a context for your data. Common Size Ratios from the Balance Sheet To calculate common size ratios from your balance sheet, simply compute every asset category as a percentage of total assets, and every liability account as a percentage of total liabilities plus owners' equity. Here is what a common size balance sheet looks like for the mythical Doobie Company: This percentage is the result of the following calculation: Additional information can be developed by adding relevant percentages together, such as the realization that Common size ratios are a simple but powerful way to learn more about your business.

This type of information should be computed and analyzed regularly. As a small business owner, you should pay particular attention to trends in accounts receivables and current liabilities.

## How to Analyze Your Business Using Financial Ratios

Receivables should not be tying up an undue amount of company assets. If you see accounts receivables increasing dramatically over several periods, and it is not a planned increase, you need to take action.

This might mean stepping up your collection practices, or putting tighter limits on the credit you extend to your customers.

- The balance sheet for the Doobie Company shows that the company can meet current liabilities;
- This is computed by dividing gross profit by sales and multiplying by 100 to create a percentage;
- Common size ratios are a simple but powerful way to learn more about your business;
- This converts the income statement into a powerful analytical tool;
- The balance sheet for the Doobie Company shows that the company can meet current liabilities.

As this example illustrates, the point of doing financial ratio analysis is not to collect statistics about your company, but to use those numbers to spot the trends that are affecting your company. Ask yourself why key ratios are up or down compared to prior periods or to your competitors.

### How to Calculate the Current Ratio

The answers to those questions can make an important contribution to your decision-making about the future of your company. Current ratio analysis is also a very helpful way for you to evaluate how your company uses its cash. Obviously it is vital to have enough cash to pay current liabilities, as your landlord and the electric company will tell you. The balance sheet for the Doobie Company shows that the company can meet current liabilities.

But you may wonder, "How do I know if my current ratio is out of line for my type of business? You may be able to convince competitors to share information with you, or perhaps a trade association for your industry publishes statistical information you can use. If not, you can use any of the various published compilations of financial ratios. See the Resources section at the end of this document. Because financial ratio comparisons are so important for bank loan officers who make loans to businesses, RMA formerly a bankers' trade association, Robert Morris Associates has for many years published a volume called "Annual Statement Studies.

RMA's "Annual Statement Studies" are available in most public and academic libraries, or you may ask your banker to obtain the information you need. It lists financial ratios for hundreds of industries, and is available in academic and public libraries that serve business communities.

These and similar publications will give you an industry standard or "benchmark" you can use to compare your firm to others. The ratios described in this guide, and many others, are included in these publications. While period-to-period comparisons based on your own company's data are helpful, comparing your company's performance with other similar businesses can be even more informative.

Compute common size ratios using your company's balance sheet. Common Size Ratios from the Income Statement To prepare common size ratios from your income statement, simply calculate each income account as a percentage of sales. This converts the income statement into a powerful analytical tool. Here is what a common size income statement looks like for the fictional Doobie Company: The gross profit margin and the net profit margin ratios are two common size ratios to which small business owners should pay particular attention.

On a common size income statement, these margins appear as the line items "gross profit" and "net profit. This is computed by dividing gross profit by sales and multiplying by to create a percentage. Remember, your goal is to use the information provided by the common size ratios to start asking why changes have occurred, and what you should do in response. For example, if profit margins have declined unexpectedly, you probably will want to closely examine all expensesâ€”again, using the common size ratios for expense line items to help you spot significant changes.

Compute common size ratios from your income statement. Look at the gross profit and net profit margins as a percentage of sales. Compare these percentages with the same items from your income statement of a year ago. Are any fluctuations favorable or not? Do you know why they changed?

## How to Analyze Your Business Using Financial Ratios

The two most common liquidity ratios are the current ratio and the quick ratio. Both are based on balance sheet items. Current Ratio The current ratio is a reflection of financial strength. It is the number of times a company's current assets exceed its current liabilities, which is an indication of the solvency of that business. Here is the formula to compute the current ratio. Doobie Company Current Ratio: The current ratio answers the question, "Does the business have enough current assets to meet the payment schedule of current liabilities, with a margin of safety?

Of course, the adequacy of a current ratio will depend on the nature of the business and the character of the current assets and current liabilities. There is usually very little uncertainty about the amount of debts that are due, but there can be considerable doubt about the quality of accounts receivable or the cash value of inventory. That's why a safety margin is needed. A current ratio can be improved by increasing current assets or by decreasing current liabilities.

Steps to accomplish an improvement include: Acquiring a long-term loan payable in more than 1 year's time. Selling a fixed asset.

- For example, the excess cash might be better invested in equipment. Obviously it is vital to have enough cash to pay current liabilities, as your landlord and the electric company will tell you.
- Compute common size ratios from your income statement.
- The quick ratio tests whether a business can meet its obligations even if adverse conditions occur. Common Size Ratios from the Income Statement To prepare common size ratios from your income statement, simply calculate each income account as a percentage of sales.
- You must always be careful when drawing conclusions from these accounting ratios. This simple process converts numbers on your financial statements into information that you can use to make period-to-period and company-to-company comparisons.

Putting profits back into the business. A high current ratio may mean that cash is not being utilized in an optimal way. For example, the excess cash might be better invested in equipment. Quick Ratio The Quick Ratio is also called the "acid test" ratio. That's because the quick ratio looks only at a company's most liquid assets and compares them to current liabilities.

The quick ratio tests whether a business can meet its obligations even if adverse conditions occur. Here is the formula for the quick ratio: Using the balance sheet data for the Doobie Company, we can compute the quick ratio for the company. Quick ratio for the Doobie Company: So the Doobie Company seems to have an adequate quick ratio.

Compute a current ratio and a quick ratio using your company's balance sheet data. In this section we will look at four that are widely used. There may be others that are common to your industry, or that you will want to create for a specific purpose within your company. The four ratios we will look at are: