Liquidity Ratios

What is working capital?

Working capital is also known as net current assets on a balance sheet. It is the difference between total current assets and total current liabilities. It can be illustrated in a formula:

Working Capital = Total Current Assets – Total Current Liabilities

A business needs enough working capital to pay staff wages when they fall due, and to pay suppliers when payment is due.

Working capital provides a strong indication of a business's ability to pay its debts.

Why is working capital important to businesses?

Working capital is important in the short-term as every business needs to be able to maintain day-to-day cash flow. This is because a business is constantly settling current liabilities and needs enough money in the short-term to pay staff wages when they fall due, and to pay suppliers when payment dates are due.

Maintaining adequate working capital is also important in the long-term. The challenge for any business is to maintain sufficient liquidity to ensure that it can survive and grow in the long-term.

What are some causes for working capital problems?

• poor control of stocks

• poor control of trade debtor

• ineffective use of trade creditor

• poor cash flow forecasting

• unexpected events

How may different industries have different working capital requirements?

• Businesses with a lot of cash sales and few credit sales (e.g. supermarkets) tend to have lower levels of working capital.

• Businesses that manufacture finished goods and also have to maintain stocks of raw materials and work-in-progress may have higher levels of working capital.

• Larger businesses may be able to use their bargaining power as customers to obtain more favourable, extended credit terms from suppliers.

• Many businesses operate in industries that have seasonal demand.

What factors affect the level of working capital within a business?

• The need to hold stock – Some businesses need to hold substantial levels of stock, e.g. retailers and distributors.

• Lean production - Businesses using lean production find that they need to hold lower levels of stock and can operate on lower levels of working capital.

• Expected credit period by customers – If long credit periods can be taken before trade debtors need to settle their invoices, it may mean that higher working capital is required.

• Effectiveness of the credit control - A poorly managed credit control department will allow customers to take too much credit and take too long to settle their bills, which will mean higher trade debtors and higher working capital.

• Credit period offered by suppliers - The longer the credit offered by suppliers, the better for cash flow and working capital.

What is the purpose of liquidity ratios?

Assesses whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due.

What are the 2 types of liquidity ratios?

• Current ratio

• Acid test ratio

How is the current ratio calculated?

Current ratio = Current assets / Current liabilities

How do you evaluate the current ratio?

• A ratio of 1.5-2 would suggest efficient management of working capital.

• Low ratio (below 1) indicates cash / liquidity problems.

• High ratio: too much working capital?

However, it is important to look out for:

• Trend (change in ratio from over a few years)

• Industry norms (e.g. supermarkets operate with low current ratios as they are low debtors).

How is the acid test ratio calculated?

Acid test ratio = Current assets - Stock / Current liabilities

How do you evaluate the acid test ratio?

• Ideal ratio is 1:1.

• It is a good warning sign of liquidity problems for businesses which usually hold stocks.

• It is less relevant for businesses with high stock turnover e.g. supermarkets or service businesses which hold a lot less stock/ none at all.