What is the Current Ratio and how why is it included in a business plan for a Plumbing and Heating Contractor?

The Current Ratio is a very important ratio for a small business like Central Plumbing & Heating Inc. It is a key measure of the liquidity of the operations of a small business. In order to calculate the current ratio, the total current assets are divided by the total current liabilities. The resulting number shows how many times the current assets of a small business like Central Plumbing & Heating Inc. can cover its current liabilities. The higher the current ratio the greater the cushion between the current obligations of a small business like Central Plumbing & Heating Inc., and the firm's ability to pay them.

If the current ratio of a small business like Central Plumbing & Heating Inc. is low - what does it mean for a business owner like Felix Gonzalez?

A current ratio of 1 means that there are enough current assets to cover the current liabilities 1 time - thus if there are certain months where the current liabilities were to exceed the current assets, the firm would have a difficult time in meeting these current liabilities and a small business owner like Felix Gonzalez would probably face a crunch that would require him to tap into a line of credit or other forms of financing in order to satisfy the current liabilities.

If a small business like Central Plumbing & Heating Inc. is constantly running at or close to a very low current ratio, then they may need to plan for those occasions where their current assets are not enough to cover their liabilities, by making sure that they have enough back up financing to meet their cash flow needs. One thing that they could do is that they could apply for a business loan in the form of a line of credit which they could use as and when they needed; it would not make sense for them to go out and get a permanent term loan since that typically does not give them the ability to draw down on the line over and over.

We highly recommend that even if the current ratio for a small business like Central Plumbing & Heating Inc. is on the higher side, that they take the time to evaluate their cash flow requirements and make sure that they have adequate financing available to take advantage of opportunities that may present themselves in the course of normal business. For example if you are a clothes manufacturer working in the very competitive garment district of New York, a line of credit may allow you to swoop in and pick up a very large consignment of clothes being liquidated by a competitor going out of business, and still not worry about meeting short term liabilities

Does the current ratio of a small business like Central Plumbing & Heating Inc. affect its competitiveness?

Yes. If a small business like Central Plumbing & Heating Inc. has a higher current ratio than its competitors, it means that it will be able to cover its current liabilities much more easily than the competition. What this of course means is that during tougher times, while the entire industry in a target market like Mecklenburg County may be facing a slowdown in sales, and a decline in revenue - Central Plumbing & Heating Inc. will be able to stay comfortably afloat and meet its obligations while its competitors may perish due to their lower cushions.

This is a very significant point that many small business owner like Felix Gonzalez fail to understand - having a good cushion simply means that ability to withstand a period of uneven cash flow is much greater and cash is king. Small businesses that are able to withstand the tougher times are the ones that come out on top and often take down market share when other more leveraged businesses are struggling to survive.

What is a current asset for a small business like Central Plumbing & Heating Inc. located in Mecklenburg County, North Carolina?

A current asset for a small business like Central Plumbing & Heating Inc. located in Charlotte, North Carolina is any asset that can be liquidated within one year or earlier. There are other definitions of current assets but we prefer to use this one. We also recommend that small business owners look at the quality of the current assets carefully before classifying them as current assets.

Thus if the small business owner like Felix Gonzalez or a business like Central Plumbing & Heating Inc. happen to have stocks, bonds and other financial assets that it can readily liquidate, they can most certainly use them in the calculation of a current assets. On the other hand if they happen to own a partnership interest in a venture capital fund or real estate, they should not include that in their current assets since they cannot be liquidated quickly.

There may be a temptation to include an asset like an automobile or other machinery in the current asset number with the thinking that you can raise some money relatively quickly by selling them off for a discount - that would be a mistake. Automobiles and other machinery are classified as fixed assets and cannot be disposed off quickly and should not be included in the current asset calculation.

Typically inventory, accounts receivables, cash and cash equivalents are what are used by a small business owner like Felix Gonzalez in the current asset calculations.

What is a current liability for a small business like Central Plumbing & Heating Inc. located in Mecklenburg County, North Carolina?

A current liability for a small business like Central Plumbing & Heating Inc. located in North Carolina, North Carolina is any liability that may have to paid within one year or earlier. Thus all notes, bonds, business loans and other payables that have to be paid within one year are classified as current liabilities. Payments of loans, lines and obligations that are longer in duration are not classified as a long time liability.

There are some business loans that require that a business clean up the loan for a period of 30 days every year - since this requires the business to pay down the entire note for a duration of 30 days or more, we recommend that it be classified as a current liability. On the other hand a typical line of credit that does not require a clean up would not be classified as current liability.

If there is a balloon payment due on a 3, 5 or 7 year note then it must be classified as a current liability for the year in which the balloon payment is due. The rationale for this is simple - for all the other preceding years only the interest and principal payments impact the business but the note itself is not due till the very end.

The proper classification of current liabilities is essential to be able to understand the nature of the pressure it will have on the cash flow of the business. Items like salaries, interest, accounts payable and other debts due within one year like loans, trade credit would all be considered to be current liabilities for a small business like Central Plumbing & Heating Inc.

Quick Links:

1. Go to the Corresponding Template section for this industry.
2. Go to the Corresponding Business Plan section for this industry.