The Current Ratio Continued: The Adjusted Current Ratio

Join guest blogger Mitchell Pauly for the second part of the current ratio definition with the math involved in the Adjusted Current Ratio.

Last week, I introduced the current ratio. This calculation can help families and businesses in dire straits determine if they have enough assets to cover liabilities when the going gets really rough. Let’s continue now with the adjusted current ratio and schedule. Warning: contains math.

The adjusted current ratio lets you know how long your current assets will last in meeting your current liabilities, as broken out and scheduled by asset type. Here is an example of a family with (for the sake of easy math) $100 in liabilities and $200 in assets. Their current ratio is obviously two. Although this is a good current ratio, how long will the money actually last and what assets need to be involved? To find that out, we would need to adjust it, effectively converting the family’s current ratio of two into a monthly expression.

Scheduling and Adjusting

Let’s take a look at the assets broken out into individual categories and scheduled by which assets we would draw down to pay liabilities first:

1) Emergency fund: $100
2) Peripheral investments (house down payment fund, new car fund): $50
3) Salable assets (car, couch, television and Jet Ski): $50

If we were to adjust this family’s current ratio, we would divide the total liabilities by the time period in question (five months, in this case). We do this because given the type of liabilities used in this ratio they are likely all paid in monthly installments (or can be). So we have a monthly liability obligation of $20 for this five month period ($100/5), our new denominator (replacing $100) in the current ratio calculation. We now know this family has enough assets to carry them through ten months (see calculations below), when all they need is five. That is more meaningful than “they have a current ratio of two.”

Let’s take this family’s schedule and calculate an adjusted current ratio for each asset type:

Emergency fund: $100/20 = 5 months
Peripheral investments: $50/20 = 2.5 months
Salable assets: $50/20 = 2.5 months
Total current assets / current liabilities: $200/($100/5) = 10 months

As you can see above, we now know that the emergency fund alone is sufficient to carry this family through its time of crisis for five months. This would be a pretty secure family. Now if we were to imagine the crisis being extended to eight months, then this adjusted current ratio schedule would let this family know that their emergency fund could carry them through the first five months before they would need to dip into any peripheral investments (which would be next on the chopping block). They would never have to touch their salable assets. Think of this as the emergency plan every family should have.

Bio:
Mitchell Pauly is a Financial Professional with experience working for Fortune 500 companies and small businesses. He enjoys investing and personal finance, comedy and sports. In his spare time he writes for various publications about personal finance, with a mind towards young adults and parents of young adults.

Photo Source

Anonymous's picture

Alex | Perfecting Dad wrote:

Tue, 10/11/2011 - 18:43 Comment #: 1

Very well discussed and I like how this ratio was brought from the business world into the family setting.

Christa Palm's picture

Christa Palm wrote:

Wed, 10/12/2011 - 16:28 Comment #: 2

Alex, thanks for the kudos! -- Mitch

Anonymous's picture

Financial Definitions - Glossary for Understanding Finances wrote:

Thu, 01/19/2012 - 21:45 Comment #: 3

[...] Adjusted Current Ratio Allocation Models Annual Percentage Yield Asset Asset [...]

Post new comment

The content of this field is kept private and will not be shown publicly. If you have a Gravatar account, used to display your avatar.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Allowed HTML tags: <a> <em> <strong> <cite> <code> <ul> <ol> <li> <dl> <dt> <dd>
  • Lines and paragraphs break automatically.