The current ratio is one of the crucial financial ratios. It is a measure of the company’s liquidity and hence it is important to both internal corporate finance and external lenders. Businesses always aim to improve their current ratio. However, there are times when reducing the company’s current ratio is imperative. The article explains when and why it is important to reduce current ratio?
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Definition of Current Ratio
Current ratio is classified as a liquidity ratio. It is a measure to determine the company’s ability to pay its current liabilities through its current assets. Thus, it is calculated by dividing the current/short term assets by the current/short term liabilities. The resultant number is a reflection of the health of the liquidity of the company. It also indicates whether the company is capable of paying its vendors and creditors on time.
How to Determine Whether Current Ratio is Higher and Lower?
The current ratio has a little significance as a standalone number. You need to take the industry standard into account before analyzing the current ratio. Therefore, the company’s current ratio needs to be compared to the industry standard to determine whether it is a higher or a lower number. However, generally, banks and other lending institutions prefer a current ratio of 1.33:1 for providing credit to the company. So, a ratio of 2:1 can be considered a high current ratio and a low current ratio means 1:1, (but it largely depends on which industry does the company belong to).
Generally, businesses aim to improve current ratio to improve the liquidity position. However, there might be situations when reducing the current ratio becomes the necessity of the hour.
Why to Reduce the Current Ratio?
If the current ratio of the company is on the higher side, this may imply that the resources are not being fully utilized. The company is keeping more than the required ‘Margin of Safety’ and, in turn, hampering its growth. This implies that the resources may be tied up in the working capital of the company and are not put to use in profitable ways. In this case, the company needs to stop playing safe and reduce the current ratio, so as to have optimum liquidity position.
Secondly, the higher current ratio also means excess cash. This excess cash might be reducing the profits of the company with implied interest cost. So, the current ratio decreased will mean more growth for the company.
In such cases, some of the below ways of reducing current ratio can come in handy.
How to Reduce Current Ratio?
If the company’s current ratio is lower than the industry standard, it definitely needs to analyze and improve it. However, the company should also not have a very high current ratio. The company can analyze what are reasons resulting in higher current ratio and work towards reducing the current ratio in the following ways:
Increase Short Term Loans
Current ratio can be reduced by increasing the current liabilities. So, the companies can increase the proportion of short-term loans as compared to long-term obligations. The companies can also reduce the duration of their long term loans, so that more portion of the loan becomes due in a particular time period, which in a way will increase the current portion of the liabilities. However, the current liabilities should be increased without any corresponding increase in the company’s current assets.
Spend More Cash Optimally
Cash is a current asset. So, spending more cash will automatically reduce the current ratio. The companies can use cash for several purposes. The cash can be used for the acquisition of fixed assets rather than using project finance. The company can also look at paying off the entire or a proportion of the long-term debt. Another effective use of cash is to pay more dividends. This will keep the investors happy as well as reduce the current ratio.
Amortization of a Prepaid Expense
A prepaid expense is an expense paid by the company in advance, such as insurance premium, rent, etc. These prepaid expenses are classified as current assets in the balance sheet. So, another way to reduce current ratio is to reduce these current assets by amortizing them over the period of time.
Leaner Working Capital Cycle
Working capital is calculated as the difference between the current assets and the current liabilities of the company. The leaner working capital cycle will ensure that the current assets can be controlled or reduced. This will help to further reduce the current ratio.
Current ratio needs to be monitored regularly to determine the liquidity position of the company. A very high current ratio is equally bad as a very low current ratio. A company needs to think clearly and look at several ways to reduce an extremely high current ratio. This will ensure that the company is able to utilize all the resources efficiently and effectively.