Working Capital & Current Accounting Ratio
The amount of current assets less current liabilities is called the working capital, or net working capital. A company needs an adequate amount of working capital on hand to meet its current or short term debts, carry sufficient inventories for resale and take advantage of cash discounts that suppliers might offer. A company that runs low on working capital is less likely to meet current debt liabilities and obligations. Current assets are those assets that can be readily or easily converted in to cash including cash, accounts receivable, inventories, short term investments, prepaid expenses and other assets that can be readily turned in to cash. Current liabilities on the other hand are those liabilities that are expected to be repaid within 1 year; examples include accounts payable, short term debts such as bank overdraft, accrued expenses such as wages payable, taxes payable and current payments on long term debt, such as bond interest.
To evaluate working capital of a company, we must look beyond the dollar values of current assets & current liabilities and we must consider the relationship between these 2 variables. The current ratio was designed to help us do just this. The current ratio is meant to describe a company’s ability to meet its short term obligations. The formula for current ratio is:
To calculate the current ratio, we will work off a simulated balance sheet of Juakali Corp. as of December 31st, 2004 and 2005 years.
The area we are interested in is the Current assets & Current liabilities area.
A high current ratio means the company is in a strong liquidity position and should easily be able to pay its suppliers, short term debts and pay its employees’ salaries, rent expenses, etc. Sometimes a company can have a very high current ratio, which means they are hoarding cash that could be put to better use such as acquiring value-added investments & companies, equipment or spend on research and development. Since current assets do not generate much additional revenue other than a measly 3% bank interest, an excessive investment in current assets is not preferable for companies.
Most investors like to see a ratio of at least 2 to 1, meaning for every $1 of short term current liability, there is $2 of cash available to pay for it. A company with a 2 to 1 ratio is also thought to be of a good credit risk in the short term. The type of business a company is in also plays a large role in maintaining a good current ratio. For instance, a service company that has little or no credit and carries no inventories other than suppliers can easily operate on a 1:1 ratio provided it generates cash in time to make its rent and other fixed cost payments. On the other hand, a company selling high priced clothes, perfumes or furniture store requires a higher current ratio of at least 2:1 because of the uncertainty in customer demand, judgement and the economy.
For example, if demand for furniture drops in the economy, the company’s inventories will not generate as much cash as expected, which means the current ratio number will be skewed higher because remember, inventories (furniture) are included as current assets. Therefore, banks and creditors as well as investors prefer to have a ratio of at least 2:1 for such companies.