The current ratio is mainly used to give an idea of the company’s liquidity position, a measure of whether or not a firm has enough resources to pay its short-term obligations over the next 12 months. It compares a firm’s current assets to its current liabilities. The current ratio can give a sense of the efficiency of a company’s operating cycle or its ability to turn its product into cash.
The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point, however this ratio can vary greatly in different industries, therefore it is best to compare your ratio to an industry benchmark.
Another liquidity ratio is the quick ratio. The quick ratio differs from the current ratio as it examines only the most liquid assets and liabilities. For example, it can take time to turn inventory into cash, therefore the ratio is often calculated as cash and accounts receivable divided by payables and any other short term debt that may come due immediately.
There are a few ways a company can improve their liquidity position, such as:
– Manage accounts receivables more effectively by taking action on overdue accounts. Bill customers more quickly in order to speed up the collection. Provide incentives to customers who pay early. Provide different credit terms to customers based upon their creditworthiness.
– Use as much trade credit or vendor financing as is reasonable/possible. It is typically free debt (in accounts payable) because it does not carry interest. Set longer terms with suppliers.
– Keep inventory/supply levels as low as possible without adversely affecting the business.
– Improve efficiencies in the businesses’ operating cycle. Get the product to the customer faster and receive payment faster.
– Good income statement management helps balance sheet performance. Increase prices selectively where possible or reduce some overhead costs to improve profitability.
– Monitor financials and prepare budget forecasts in order to predict and prepare for potential cash shortfalls that may occur.
– Sell unproductive assets that are not contributing sufficiently to the generation of income.
– Relieve short-term debt pressures by moving it to a long-term debt if possible as this may lower cash payments.
– Sell receivables to collect funds faster. Although this may result in obtaining fewer funds than owed, it can be an effective way to strengthen the cash position of the company if you are in a crunch.
For more information, contact us at 204-478-7266 x110.
|This article originally appeared in the September 2011 edition of The Beal Business Advisor. The issue also included:
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