Working Capital

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18 / Jan / 2012

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10 financial concepts you should master 

Here is lesson two in unwrapping essential financial concepts and how they will help you run your business.

Working capital ratio 

This is also known as the current ratio. It works to a simple formula – your current assets (assets that will last less than 12 months, like cash and accounts receivable) divided by your current liabilities (assets you will need to pay in the next 12 months).

Why is this ratio important? Working capital ratio is critical because it indicates the ability of the business to pay its current liabilities when they fall due during the next 12 months.

In other words, working capital ratio is a very simple indicator of solvency. It looks at the money the business needs to fund normal, day-to-day operations in the short term.

A strong working capital ratio or current ratio ensures that the business runs smoothly while the business owner waits for money owed to arrive. A strong ratio also ensures that the business has enough cash to pay its debts and expenses as they fall due.

Here is how the formula works. Let’s say you have $1000 cash, debtors owe you $2000 and you owe creditors $1500. That leaves you with $3000 in current assets (cash of $1000 and debtors owing you $2000) and $1500 in current liabilities.

That means your level of current assets is double how much you owe in liabilities. That leaves you with a ratio of 2, or twice as many current assets as current liabilities which means you can pay your short-term liabilities comfortably.

As a rule, a stronger ratio means there is less pressure on cash flow as long as you collect your debtors and sell your stock on a timely basis.

It becomes a problem when you have a current ratio of less than 1, because that will show your current assets are less than your current liabilities.

For example, you might have $1000 in cash, no debtors and you owe creditors $1500 which means you have a current ratio of just .66 ($1000 of assets divided by $1500 in liabilities).

It means you don’t have enough current assets to cover your current liabilities, which is an indicator that you may not be able to pay debts when they fall due during the next 12 months.

That tells the business owner they have to do something to generate cash or current assets in the short term that can be converted to cash in order to pay current liabilities.

Businesses are advised to carefully monitor and budget working capital so steps can proactively be taken when it is clear that current assets will be less than current liabilities at a point in the future.

When current assets are less than current liabilities owners are sometimes advised to put a statement into their financials indicating that the owners will provide a guarantee over the liabilities because the ratio is the basic indicator of solvency.

A ratio of 2 is usually regarded as desirable. Anything below 1 suggests the business could be in trouble. But if the ratio is too high, for example 4, the business might have surplus funds not earning a return.