The Current Ratio: a Measure of Security

Join guest blogger Mitchell Pauly for a serious definition: the current ratio.

Life can turn inexplicably bad, a fact of life that ranks up there alongside death and taxes. I have recently discovered this far more intimately than I wish; my aunt was diagnosed with terminal cancer. As she begins her first round of chemotherapy and begins to lose her hair, my thoughts turn to her family’s current financial situation.

Prior to the diagnosis, the feeling of security in the household was slim, but it is now nonexistent in the absence of a primary bread winner. My aunt has always struggled to make money, and right now, to make matters more trying, her daughter is currently in her last semester of technical school. Although my cousin has a job lined up post-graduation, she may not be able to graduate on time.

So this past weekend I worked to determine if indeed they were in as bad a fix as they thought they were. One of the measures I used in my analysis was the Current Ratio, a measure of a company (or person’s) ability to pay their short-term liabilities with short-term (or hereby referred to as “current”) assets.

The Current Ratio

This ratio is a black and white calculation in the world of business. Simply put, it divides the current assets by current liabilities. Expressed as a percentage, a number of one suggests that there are exactly enough current assets salable to cover current liabilities, so logically the higher the number the better. I made this number a central part of my analysis not because this ratio is inherently the most useful tell-all in finance but because from an emotional standpoint it can provide a lot of reassurance to a family in crisis. It tells you that if things get truly dire you either are or are not able to utilize your existing current assets to meet your current obligations.

What is “Current”?

It may be tricky to define what “current” really is. This will obviously depend heavily on the situation. For example, U.S businesses utilize the GAAP (Generally Accepted Accounting Principles), which does not apply to individuals. For individuals, a good default period in the absence of crisis is sixth months.

In the case of my family we defined the “current” period as the time needed for her daughter to graduate technical school and begin work. Given that, we added up all current assets: cash, non-retirement investments and equivalents (peripheral investments) and any item with cash value that could be written off in a short-sale. We then added all current liabilities, which we defined as all periodic debt (so we added up the monthly credit card, mortgage and other debt related payments for the time period in question) plus bare-bones lifestyle expenses such as gas, food, phone, etc.

A Sanity Saver

You may be thinking that this is essentially the same as the age-old advice financial advisors give about the importance of emergency funds: roughly six months worth of expenses should be sacked away (hence my default time period). The sacking away in this advice is always meant to be in the form of cash, not baseball cards or collectable action figures. In a perfect world everyone would have six months worth of expenses saved away; the reality is that most families aren’t even close.

This is where the current ratio is a sanity saver because it expands the “emergency fund” from simply cash to include peripheral investments (like the money you’ve saved for a down payment, for example) and short-salable assets. It might not be as bleak a picture after they are included (or, you know, it could still suck).

In the case of my aunt’s family, we identified enough current assets to be able to carry them through. In a time of great financial hardship and emotional turmoil, they can take comfort in knowing that they are currently able to meet all of their obligations.

Stay tuned: next week we’ll look at the math involved in the adjusted current ratio.

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.

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Financial Definitions: Interest Coverage Ratio | MomVesting wrote:

Mon, 10/31/2011 - 11:15 Comment #: 1

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Financial Definitions - Glossary for Understanding Finances wrote:

Thu, 01/19/2012 - 21:46 Comment #: 2

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