Question

1. The bank of Joy Williams is reluctant to increase the line of her credit because of the high current ratio as shown in her current financial statements. Accordingly, she looks for authoritative guidance that helps her to find out financial arraignments to exclude the substantial amount of short-term obligations from current liabilities.

Answer 1

The current ratio is an indication of firms' liquidity. If the companies current ratio is too high it may indicate that the company is not effectively using its current assets or its short term financing facilities.

The high current ratio implies that the company's resources aren't fully utilized. Secondly, it means excess cash. This excess cash might be reducing the profits of the company with implied interest costs. To reduce the high current ratio

• Increase short term loans
• spend more cash optimally
• amortization of a prepaid expense
• learner working capital cycle

INCREASE SHORT TERM LOANS

We can reduce the current ratio by increasing the current liabilities. So, companies can increase the proportion of short-term loans as 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 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. The companies can use cash for several purposes. The cash can be used for the acquisition of 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 which a company pays in advance, such as insurance premiums, rent, etc. These prepaid expenses are classified as current assets in the balance sheet. So, another way to reduce the current ratio is to reduce these current assets by amortizing them over the period.

LEANER WORKING CAPITAL CYCLE

The difference between the current assets and the current liabilities of the company is working capital. The current assets are those which are converted into cash within a year. It includes accounts receivable, cash, short-term investments, etc. Whereas 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 further reduce the current ratio.

The company needs to keep monitoring the current ratio regularly to determine the liquidity position of the company. 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.