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 this ratio. However, there are times when it is imperative, and one has to reduce the current ratio. The article explains when and why it is important to reduce the ratio?
Definition of Current Ratio
The current ratio is a liquidity ratio and is also called the working capital ratio. It is a measure to determine the company’s ability to pay its current liabilities through its current assets. Thus, we calculate it 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 little significance as a standalone number. You need to consider the industry standard before analyzing the current ratio. Therefore, one has to compare the company’s current ratio to the industry standard to determine whether it is a higher or a lower number. However, banks and other lending institutions generally prefer this ratio of 1.33:1 to provide credit to the company. So, a ratio of 2:1 can be considered on a higher side and 1:1 on a lower side (but it largely depends on which industry does the company belongs to).
Generally, businesses aim to improve the current ratio to improve liquidity. However, there might be situations when reducing this ratio becomes the necessity of the hour.
Why Reduce the Current Ratio?
If the company’s current ratio 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 company’s working capital and are not put to use in profitable ways. In this case, the company needs to stop playing safe and reduce it so as to have an optimum liquidity position.
Secondly, the higher ratio indicates excess cash. This excess cash might reduce the company’s profits with implied interest costs. So, the decreased current ratio will mean more growth for the company. We shall discuss some useful ways of reducing the same in such cases.
How to Reduce Current Ratio?
If the company’s current ratio is lower than the industry standard, it definitely needs to analyze and improve. However, it should also not have a very high ratio. It should analyze what are reasons resulting in a higher current ratio and work towards its reduction in the following ways:
Increase Short Term Loans
We can reduce the current ratio by increasing the current liabilities. So, the companies can increase the proportion of short-term loans 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. Companies can use cash for several purposes. The cash can be used to acquire 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 this ratio.
Amortization of a Prepaid Expense
A prepaid expense is an expense that a company pays in advance, such as insurance premium, rent, etc. These prepaid expenses are classified as current assets on the balance sheet. So, another way to reduce the current ratio is to reduce these current assets by amortizing them over a period of time.
Leaner Working Capital Cycle
The difference between the current assets and the company’s current liabilities is working capital. The current assets are those assets that the company can convert into cash within a year. It includes accounts receivable, cash, short-term investments, etc. At the same time, the current liabilities include accounts payable, short-term obligations, etc. The leaner working capital cycle will ensure control or reduction of the current assets. This will help to reduce the current ratio further.
The company needs to regularly monitor the current ratio to determine its liquidity position. A higher ratio is equally bad as a lower one. A company needs to think clearly and look at several ways to reduce an extremely higher ratio. This will ensure that the company can utilize all the resources efficiently and effectively.