The current ratio is a critical liquidity ratio utilized extensively by banks and other financing institutions while extending loans to the businesses. “How to improve current ratio?” is a very common question which keeps hitting the entrepreneur’s mind every now and then. For improving current ratio, the management needs to focus on various strategies including its current liabilities and assets which are not a onetime activity. It has to be monitored throughout the year.
The current ratio is a figure resulted from dividing current assets by current liabilities of a firm. This figure is important because it measures the liquidity stand of a firm. Normally, it is assumed that higher the ratio, higher is the liquidity and vice versa. It would be unfair if the liquidity is concluded just on the basis of the ratio. Without going further to know what is making that ratio, it is difficult to form an opinion over it. It can be well explained with the following situations:
- Normally, a dipping sale would increase the level of inventories. Claims of creditors cannot be settled with inventory, it would require hard cash. Undoubtedly, the ratio, in this case, is increasing but without improving the liquidity.
- Secondly, delayed payments by customers will lead to increase the debtor’s level and eventually the current assets and therefore the current ratio. Here also, we can see the increase in the current ratio but a decline in the real level of liquidity.
It can be well established with the above examples that a current ratio of 1:1 is not sufficient because all the current assets are not easily converted into cash. A cushion over and above 1 is always required. This cushion is technically called “Margin of Safety”. In other words, current assets over and above the current liabilities are the margin of safety. We need marginal current assets simply as all the current assets are easily liquidated to cash.
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How to improve the current ratio?
Faster Conversion Cycle of Debtors or Accounts Receivables
Faster rolling of money via debtors will keep the current ratio in control. At least, the ratio will show the correct picture if the debtors are liquid. A constant follow up with the debtors can improve the collections from them. In the first dealing itself, the payment terms should be made clear and should negotiate credit period as low as possible.
Pay off Current Liabilities
Not only does the current ratio depend on current assets, it is equally dependent on the current liability which is the denominator. They should be paid off as often and as early as possible. It would decrease the level of current liabilities and therefore, improve the current ratio. Early payments to creditors can save interest cost and earn discount which will have a direct impact on the profits of the firm.
Sell-off Unproductive Assets
Cash level can be increased by selling unused fixed assets. Otherwise, the money is unnecessarily blocked into them and idle money accrues interest cost.
When the current assets are financed by equity rather than the creditors, the level of current assets would increase with current liabilities remaining the same. Consequently, this exercise will improve the current ratio. Taking the improvement of current ratio into view, drawings are not advisable. It is because drawings would reduce capital invested in the current assets and therefore the level of current liabilities will increase to finance the current asset. All this directs impacts the current ratio. In essence, owners fund i.e. capital and reserves and surpluses should remain invested in the firm to balance the current ratio.
Sweep Bank Accounts
First of all, the management of the firm should always try to cut down on hard cash levels and keep the money in bank accounts. Facility of sweeping should be availed in the bank accounts which almost every bank and the financial institution are providing. Sweeping is a facility by which excess fund are transferred from current account to another account which fetches interest on that fund. At the same time, these funds are available to use when required.
Our conversation above is mainly focusing on analyzing and improving the current ratio. Normally, the rule for this ratio is “higher the better”. It would be quite interesting to know that in certain situations, it is advisable to reduce the current ratio. Let’s check out Why and How to Reduce Current Ratio?Last updated on : March 23rd, 2019