How Can a Company Improve Its Current Ratio?
Understand how operational efficiencies and strategic financial choices can directly improve a company's liquidity and short-term stability.
A company’s current ratio is calculated by dividing its total current assets by its total current liabilities. This figure provides a snapshot of a company’s ability to meet its short-term obligations, which are debts due within one year. Lenders and investors monitor this ratio to gauge operational efficiency and financial stability. A low ratio may signal difficulty paying bills, while a very high ratio might suggest a company is not using its assets efficiently.
Current assets include cash, accounts receivable, inventory, and other assets expected to be converted to cash within a year. Current liabilities consist of accounts payable, short-term loans, accrued expenses, and the portion of long-term debt due within the next twelve months.
Enhancing Current Asset Management
One primary method for improving the current ratio is accelerating the collection of accounts receivable. Implementing clear credit policies, such as requiring partial payment upfront or setting shorter payment windows, can prevent delays. For existing receivables, offering a small discount for early payment can incentivize customers to settle their balances faster.
Another approach centers on optimizing inventory. Holding excess inventory ties up cash and risks becoming obsolete. Companies can analyze sales data to identify and liquidate slow-moving products, even if it requires offering discounts. Adopting a just-in-time (JIT) inventory system, where materials are ordered only as needed, can also reduce the capital tied up in goods.
A company can also bolster its current assets by selling non-current assets that are not essential for its core operations. This could include surplus machinery, unused company vehicles, or land not part of future expansion plans. The proceeds from such a sale are recorded as cash, directly increasing the total current assets and converting an unproductive asset into liquid capital.
Reducing Current Liabilities
A direct way to improve the current ratio is to lower short-term obligations by using available cash to pay them down. A company might prioritize paying off high-interest short-term loans or reduce its outstanding accounts payable balance. This action decreases the denominator in the current ratio formula, leading to an immediate improvement.
A more structural approach involves refinancing short-term debt into long-term obligations. A business could, for example, secure a term loan with a maturity of several years and use the funds to pay off a revolving line of credit or other debts due within the current year. While the company’s total debt may not change, this process moves a liability from the “current” to the “long-term” category, increasing the current ratio.
Utilizing Strategic Financing
A company can improve its current ratio by securing a new long-term loan. When a company receives the proceeds, its cash balance increases, which boosts its current assets. Since the loan is structured with a repayment period extending beyond one year, the debt is recorded as a long-term liability. This transaction strengthens the current ratio by increasing the numerator without affecting the denominator.
A different strategic financing option is to issue new equity. This involves selling ownership stakes in the company to investors in exchange for cash. The cash received from the equity issuance increases current assets, but unlike debt financing, it does not create a corresponding liability that needs to be repaid.
This course of action is a significant corporate decision that involves complex legal and financial processes. It can dilute the ownership percentage of existing shareholders but provides the company with permanent capital that does not carry interest payments or maturity dates. For businesses in a growth phase, raising equity capital is a strategic move.