Strategies to improve liquidity ratios
Strategies to Improve Liquidity Ratios
When a business identifies that its liquidity ratios are below acceptable levels — particularly if the acid test ratio falls well below 1:1 — it must act to improve its ability to meet short-term obligations. The strategies available target different components of the liquidity equation: increasing current assets (particularly cash), reducing current liabilities, or accelerating the conversion of existing assets into cash. Each approach carries trade-offs that must be weighed carefully in context.
Reduce stock levels
Since stock is the least liquid current asset and its size drives the gap between the current ratio and the acid test ratio, reducing stock holdings improves the acid test ratio directly and releases cash that was previously tied up in inventory. Strategies include adopting just-in-time (JIT) stock management (ordering stock only as needed, eliminating buffer stock), running promotional offers to clear slow-moving stock, or rationalising the product range to eliminate low-turnover lines.
The risk is that lower stock levels increase the danger of stockouts — running out of goods when customers want them — which can damage sales and customer relationships. JIT also increases dependence on reliable suppliers; a supply chain disruption can halt production entirely.
Improve debtor collection
Debtors — customers who owe the business money — represent cash that has been earned but not yet received. Accelerating the collection of debts converts debtors into cash, improving both liquidity ratios. Strategies include tightening credit terms (reducing the standard payment period from 60 to 30 days), offering early payment discounts, pursuing overdue accounts more aggressively, or using a factoring arrangement (selling the debt book to a specialist company at a discount in exchange for immediate cash).
The risk is that tighter credit terms or aggressive debt collection may damage relationships with customers, particularly long-standing ones who rely on extended credit as part of their own working capital management. Early payment discounts reduce revenue per transaction.
Extend creditor payment periods
Extending the time taken to pay suppliers — negotiating longer trade credit terms — increases current liabilities but also delays cash outflows, improving the business's short-term cash position. If the payment period is extended without penalty or interest, this is effectively free short-term finance. However, it relies on suppliers agreeing to extend terms, which they may decline if they perceive the business as a credit risk. Consistently delaying payments beyond agreed terms risks damaging supplier relationships, losing trade credit facilities, or being required to pay upfront in future.
Sell assets
Selling non-current assets — surplus property, redundant machinery, or underutilised vehicles — converts long-term assets into cash, increasing current assets and improving both liquidity ratios. A sale and leaseback arrangement (as introduced in Section 3.2) allows the business to release capital from an asset whilst retaining its use. However, asset disposals are one-off measures and may reduce productive capacity if the assets sold were in active use.
Arrange additional short-term finance
Securing an overdraft facility or a short-term loan provides an immediate cash buffer. An overdraft facility does not itself improve liquidity ratios (it adds to current liabilities), but it provides the practical ability to meet obligations even if ratios suggest tightness. Some businesses also raise additional equity finance or convert short-term liabilities into long-term ones — for example, refinancing an overdraft as a term loan — which reduces current liabilities and directly improves the ratios.
| Strategy | Mechanism | Ratio effect | Key risk or trade-off |
|---|---|---|---|
| Reduce stock levels | Converts stock to cash; reduces least-liquid asset | Improves acid test directly; current ratio unchanged unless cash rises | Stockout risk; supply chain vulnerability if JIT adopted |
| Improve debtor collection | Accelerates cash inflow from credit sales | Increases cash component of current assets; improves both ratios | May damage customer relationships; discounts reduce revenue |
| Extend creditor payment periods | Delays cash outflow; conserves existing cash | Does not directly improve ratios but preserves cash for other uses | Requires supplier agreement; risks relationship damage if overused |
| Sell non-current assets | Converts fixed assets to cash; raises current asset level | Improves both ratios; increases cash immediately | One-off; may reduce capacity; sale and leaseback adds ongoing overhead |
| Refinance short-term debt as long-term | Moves current liabilities to non-current liabilities | Reduces current liabilities; directly improves both ratios | Long-term interest commitment; lender agreement required |
Following the deterioration in its liquidity ratios (current ratio: 1.68:1; acid test: 0.77:1), the management of Fenwick Ironworks Ltd identifies three priority actions.
First, it launches a review of slow-moving finished goods stock, identifying £95,000 of components that have been in the warehouse for over six months. It offers these at a 15% discount to existing customers, generating approximately £81,000 in cash and reducing the stock holding. This directly improves the acid test ratio.
Second, it introduces a 2% early payment discount for customers settling within 14 days (compared with standard 60-day terms). Several key accounts take up the offer, accelerating approximately £120,000 of debtor receipts into the current month. The 2% discount reduces revenue by approximately £2,400 — a cost the directors judge worthwhile given the liquidity improvement.
Third, it approaches its bank to refinance the £114,000 overdraft as a 24-month term loan. This moves the overdraft from current liabilities to non-current liabilities, directly reducing current liabilities and improving both ratios without any change in the underlying cash position. The bank agrees, subject to a review of the company's financial projections.
These three actions together demonstrate a targeted, multi-pronged approach to liquidity management — each addressing a different component of the working capital cycle rather than relying on a single intervention.
Key Takeaways
- Liquidity can be improved by increasing liquid current assets (cash, debtors converted to cash), reducing current liabilities, or converting non-liquid assets into cash.
- Reducing stock improves the acid test ratio directly; improving debtor collection increases cash and improves both ratios; refinancing short-term debt as long-term reduces current liabilities.
- Every strategy carries a trade-off: JIT increases stockout risk; tighter credit terms may damage customer relationships; asset sales are one-off and may reduce capacity.
- Extending creditor payment periods helps preserve cash but does not improve the ratios themselves — it is a cash management tool rather than a ratio-improvement strategy.
- The most appropriate strategy depends on the root cause of the liquidity problem: a stock-heavy business needs different solutions from one with slow debtor collection or excessive short-term borrowing.