1) Working Capital
Working capital is a measure of a
firm's ability to pay off short term debt and have enough
money to finance its day to day business operations. The
formula for Working Capital is:
| Working
Capital = Current Assets - Current Liabilities |
Therefore, if Current Assets are
greater than Current Liabilities, than the firm is financially
healthy in the short term. However, if Current Liabilities
are greater than Current Assets, the company may have
to borrow additional debt (bond
financing) to finance its day to day business operations,
and if conditions do not change, it may be heading towards
bankruptcy.
A low ratio of Current Assets could
indicate that the company is having a hard time getting
Cash Sales and thus focusing its business on Accounts
Receivable Sales. It also indicates that the company is
having a hard time collecting these accounts receivable
sales (customers are not paying on time, or not paying
at all).
If Working Capital is low, this can
also indicate the company's business operations are not
very efficient. The cycle of making a sale, collecting
the cash and paying down current expenses is not at optimum
level and needs to be improved.
2) Current Ratio
The current ratio is a measure of
a firm's short term liquidity. The formula is:
| 2)
Current Ratio = Current Assets / Current Liabilities |
Current Ratio Example
Coco Corp. has $175,000 in Current
Assets and $120,000 in Current Liabilities. The Current
Ratio in this case would be:
| Current
Ratio = $175,000 / $120,000 = $1.46 |
This means that for every $1 of debt
or liability, Coco Corp. has $1.46 of Cash. This means
the short term debt of the firm is covered over by 1.46
times. The general rule of thumb is the higher the current
ratio, the better. Most investors prefer a Current Ratio
of 2:1 meaning $2 of Current Assets for every $1 of Current
Liabilities.
What about a Current Ratio of $3?
You would think, hey that's a fantastic ratio! Not really.
This is because a Current Ratio of $3 means the company
has too much cash on hand, that could be used for better
purposes such as:
- Expanding Business Operations
- Investing in Short Term Securities and earning interest.
3) Quick or Acid-Test Ratio
The Quick or Acid-Test Ratio is very
similar to the Current Ratio only that it eliminates Inventory
and Prepaid Assets from the calculation of Current Assets.
Why inventory? Inventory is often the least liquid current
asset that the company can hold. Inventory is also prone
to obsolescence, damage or theft. Furthermore, a large
amount of inventory being held shows operation inefficiency
of the firm. Thus, the formula for Acid-Test Ratio is:
| 3)
Acid-Test Ratio = (Current Assets - Inventory - Prepaid
Assets) / Current Liabilities |
In order to measure the TRUE short
term liquidity of a firm, the Acid-Test ratio does a much
better job than the Current Ratio.
Acid-Test Ratio Example
Coco Corp. has $175,000 in Current
Assets and $120,000 in Current Liabilities. Furthermore,
out of the $175,000 in Current Assets, $90,000 is Inventory.
What is the Quick or Acid-Test Ratio?
Acid-Test Ratio = [($175,000 - $90,000) / $120,000]
Acid-Test Ratio = $85,000 / $120,000
Acid-Test Ratio = $0.70 |
What does an Acid-Test Ratio of $0.70
tell you? It shows a sign of too much inventory being
held up and NOT getting sold (therefore inefficient business
operations of the firm). Furthermore, if all of the Creditors
of the company were to demand their money at this time,
Coco Corp. would not have sufficient reserves to pay off
its short term debt (it has only $0.70 of liquid cash
for every $1 in short term debt).
