Current Ratio: Strategies for Improvement
1. Increase Current Assets
- Retain Profits: Instead of distributing all profits as dividends, retain some to boost cash reserves or invest in other current assets.
- Improve Accounts Receivable Collection: Speed up the collection of payments from customers to increase cash flow.
A retail business could retain profits to increase its cash reserves, improving its current ratio.
Consider offering discounts for early payments or implementing stricter credit policies.
2. Reduce Current Liabilities
- Pay Off Short-Term Debts: Use available cash to reduce liabilities, such as overdrafts or short-term loans.
- Negotiate Better Credit Terms: Work with suppliers to extend payment deadlines, reducing the immediate burden of liabilities.
Be cautious not to deplete cash reserves entirely, as this could create liquidity issues.
A manufacturing firm could negotiate 60-day payment terms instead of 30 days, easing short-term cash flow pressures.
3. Optimize Inventory Management
- Reduce Overstocking: Excess inventory ties up cash that could be used to pay liabilities.
- Implementing just-in-time (JIT) inventory systems can help.
- Convert Inventory to Cash: Focus on selling slow-moving or obsolete inventory to free up cash.
A clothing retailer could use data analytics to forecast demand more accurately, reducing excess stock.
Consider running promotions or discounts to accelerate sales of stagnant inventory.
Acid Test Ratio: Strategies for Improvement
1. Improve Accounts Receivable
- Faster Collections: Prioritize collecting outstanding debts to increase cash flow.
- Reduce Bad Debts: Implement stricter credit checks to minimize the risk of non-payment.
A service-based business could implement automated reminders for overdue invoices, reducing the average collection period.
Regularly review customer creditworthiness to identify potential risks early.
2. Manage Inventory Levels
- Minimize Inventory: Since inventory is excluded from the acid test ratio, reducing stock levels can improve this metric by freeing up cash.
- Focus on Liquid Assets: Prioritize investments in cash or near-cash assets rather than inventory.
Avoid reducing inventory to the point where it affects your ability to meet customer demand.
A tech company could invest surplus cash in short-term, easily liquidated securities to maintain liquidity.
3. Control Short-Term Liabilities
- Pay Off High-Interest Debts: Prioritize paying off liabilities that accrue high interest, reducing the overall burden on liquid assets.
- Negotiate Payment Terms: Extend payment deadlines with suppliers to retain cash longer.
Building strong relationships with suppliers can make it easier to negotiate favorable terms.
Balancing Liquidity and Operational Needs
- While improving liquidity ratios is important, businesses must also consider the broader impact of these strategies.
- For example, retaining too much cash may limit investments in growth opportunities, while reducing inventory excessively could lead to stockouts.
How would a change in organisation affect the profitability and liquidity of a business.
- A common mistake is focusing solely on improving ratios without considering the underlying business operations.
- Ratios should reflect a healthy financial position, not just short-term adjustments.
Due to rising importance of qualitative aspects of businesses, do you think the accounting system should upgrade by including human capital and other intellectual aspects and be measurable in terms of money?
