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How liquid is your business? The answer lies in a metric called the current ratio, also known as the working capital ratio, which indicates your ability to repay short-term debts in the next 12 months. Keeping an eye on this number can help you gauge the company’s financial health as you increase liquidity. By taking steps to improve the current ratio, you increase liquidity and raise the business’ standing in the eyes of lenders, investors, and other stakeholders.
How can a company improve its current ratio? This comprehensive guide to business liquidity gives you strategies that will move the needle in a positive direction.
Before you learn how to improve current ratio, you have to know how to calculate this number. The formula for a current ratio is simple: Divide the company’s current assets by its current liabilities. In the assets category, be sure to account for:
Liabilities include all your company’s outstanding debt obligations as well as short-term notes, accrued income taxes and expenses, accrued compensation, and deferred revenues. It also covers the portion of long-term debt due in the next year.
Let’s look at an example calculation to help you understand how to increase liquidity. If your company has $10 million in assets and $8 million in debts, its current ratio is 10/8 or 1.25. In other words, for every $1 in debt, your company has $1.25 in corresponding assets.
A ratio greater than 1 represents the favorable financial position of having more assets than debts. Conversely, a current ratio lower than 1 means the business’ debts exceed its assets, which can be a red flag for financial danger and signifies that you need to improve liquidity. A ratio higher than 3 could show an inefficient use of working capital.
You might also hear about another key metric, the quick ratio. Like the current ratio, the quick ratio measures your company’s short-term liquidity, but it accounts for fewer assets, which creates a more conservative estimate. To find your quick ratio, start with the current ratio equation. For assets, count only accounts receivable, sellable stocks and securities, cash, and cash equivalents. Use the same debts as with the current ratio calculation. If you’re wondering how to improve quick ratio, boosting your current ratio will put you on the right path.
The ideal current ratio varies by industry, but you should aim to be at or above the average in your sector. Fortunately, smart strategies can change the direction of this number for the better.
Repaying or restructuring debt will raise the current ratio. Explore whether you can reamortize existing term loans and change how the lender charges you interest, effectively delaying debt payments so they drop off your current ratio. Negotiate longer payment cycles whenever possible. For example, you may be able to shift short-term debt into a long-term loan to reduce its impact on liquidity.
With a sweep account, the company’s cash on hand can earn interest while remaining available for operating expenses. These accounts “sweep” excess cash into an interest-bearing account and return them to your operating account when it’s time to pay bills.
Consider selling unused capital assets that don’t create a return. This cash infusion increases your short-term assets column, which, in turn, increases the company’s current ratio. Buildings, equipment, vehicles, outdated inventory, and other items that do not bring funds into the business represent liabilities you can convert to cash.
If outstanding accounts payable have reduced the company’s liquidity, consider amplifying efforts to collect on these debts. Issue invoices as quickly as possible after a purchase. Establish clear payment terms at the outset, including late fees and interest on past-due balances. Conduct a close review of the business’ accounts payable process and look for inefficiencies that delay payments and prevent prompt collections.
If possible, cut down on spending to increase current ratio. Review the budget carefully and see where you can reduce line items like marketing, advertising, labor, and services. These indirect costs add up over time and take a big chunk out of your operating assets, but they often go unnoticed.
At the same time, consider limiting personal draws on the business. By taking these profits out of circulation, you reduce the amount of available operating capital, decreasing your current ratio. The more cash you dedicate to operating the company, the better current ratio you’ll achieve.
Whenever possible, finance or delay capital purchases that require a significant outlay of cash. Spending your operating funds on major expenses will quickly draw this ratio below 1.
Keep in mind that the company’s current ratio naturally changes over time as you repay debt and acquire new assets and debts. Now that you know how to improve liquidity, monitoring this number periodically helps you stay on track and illustrates the impact of implementing these strategies.