‘Working capital is a measurement’ often used to express the”Relationship between cur- ‘rent assets and current liabilities. Working capital is the excess of current assets over . current liabilities. Computer Barn’s working capital amounts to $80,000, computed as follows Recall that current assets are expected to convert into cash within a relatively short period of time, and that current liabilities usually require a prompt cash payment.
Thus working capital measures a company’s potential excess sources of cash over its upcoming uses of cash.
The amount of working capital that a company needs to remain solvent varies with the size of the organization and the nature of its business activities.2 An analyst familiar with the nature of a company’s operations usually can determine from the amount of working capital whether the company is in a sound financial position or is heading for financial difficulties.
Current Ratio The most widely used measure of short-term debt-paying ability is the current ratio. This ratio is computed by dividing total current assets by total current liabilities.
In the illustrated balance sheet of Computer Barn, current assets amount to $180,000 and current liabilities total $100,000. Therefore, Computer Barn’s current ratio is I.B to 1″ computed as follows A current ratio of 1.8 to 1 means that the company’s current assets are 1.8 times as large as .its current liabilities, higher the current ratio, the more liquid the company appears to be.
Many bankers and other short-term creditors traditionally have believed that a retailer should have a current ratio of at least 2 to 1 to qualify as a good credit risk. By this standard, Computer Barn comes up a little short; the company might not receive a top credit rating from a bank or other short-term creditor.
Quick Ratto Inventory and prepaid expenses are the least liquid of the current assets. In a business with a long operating cycle, it may take many months to’ convert inventory into cash. Therefore, some short-term creditors prefer the quick ratio to the’ current ratio as a measure of short-term solvency.
The quick ratio compares only the most liquid current assets-called quick assets with current liabilities. Quick assets include cash, marketable securities, and receivables- the. current assets that can ‘be converted most quickly into cash. Computer Barn’s quick ratio is 1.06 to 1, computed as follows: 2A company with current capabilities excess of its current 11.s a negative amount or working capital.
Negative working capital does not necessarily mean that a company is insolvent.
Any company with a current ratio of less than I to I has a negative amount of working capital. As explained in the Case in Point on the next page, telephone companies may fall into this category.Quick ratios are especially useful in evaluating the liquidity of companies that have inventories of slow-moving merchandise (such as real estate), or inventories that have’ become. excessive in size. Debt Ratio
If a business fails and must be liquidated, the claims of creditors take priority over those of the owners. But if the business has a great deal of debt, there may not be enough assets even to make full payment to all creditors. A basic measure of the safety of creditors’ claims is the debt ratio, which states total liabilities as a percentage of total assets.
A company’s debt ratio is computed by dividing total liabilities by total assets, as shown below, for Computer Barn: The debt ratio is not a measure of short-term liquidity. Rather, it is a meaure of creditors’ long-term risk. The smaller the portion of total assets financed by creditors, the smaller the risk that the business may become unable to pay its debts. From the creditors’ point of view, the lower the debt ratio, the safer their position.
Most financially sound American companies traditionally have maintained debt ratios under 50%. But again, the financial analyst must be familiar with industry characteristics. Banks, .for example, have very high debt ratios-often over 90%. Evaluating Fin’ancial Ratios.
We caution users of financial statements against placing much confidence in ‘rules of thumb, such as a current ratio should be lit least 2 ‘to I, a quick ratio should be at least 1 to 1, or that a debt ratio should be under 50%. To interpret any financial ratio properly, the decision maker must first understand the characteristics of the company and the industry in which it operates. Retailers, for example, tend to have higher current ratios than do wholesalers or manufacturing companies. Service-type businesses=-which have no inventory peripherally have’ lower current ratios than merchandising or manufacturing companies.
Large businesses with good credit ratings and. reliable sources of cash receipts are able to operate with lower current ratios than are small companies whose continuous inflow of cash may be less predictable.
Although a high current ratio is one indication of strong debt-paying ability, an extremely high ratio-say 4 or 5 to i-may indicate that too much of the company’s resources are tied up in current assets.
In maintaining such a highly liquid position. the company may be’ using its financial resources inefficiently