Liquidity or Working Capital Ratios
Cash Conversion cycle is just one part of assessing the working capital position.
Other is the computation of
- Current Ratio,
- Acid-test Ratio and
- Cash Ratio.
Current Ratio
Current Ratio is the basic and the most used amongst the list of liquidity ratios.
It is also known as working capital ratio and is stated as below:
Current Ratio= Current Assets/ Current Liabilities
The resultant figure represents the number of times current assets cover current liabilities.
Higher the ratio better it is.
However, this ratio can be higher even if cash is trapped in receivables and inventories.
Acid Test Ratio
Acid test ratio is also known as quick ratio and it considers only “highly” liquid assets in consideration.
Acid Test ratio = (Current Assets- Stock- prepaid expenses)/ Current Liabilities
Acid test ratio doesn't include inventories but does include receivables and so thought a refinement of current ratio may still mislead at times
Cash Ratio
This one is a further refinement of Acid Test ratio and considers only Cash and cash equivalents for the purpose of measuring liquidity.
Cash Ratio = Cash + Cash equivalents / Current liabilities
The above ratios and Cash Conversion Cycle determine the working capital position of a company.
However, we always maintain that one aspect of the entire financial position cannot be considered as representative of the total financial health of a company.
So here are a few cautionary words for cases when you just have working capital figures to contend with.
Factors to consider when assessing working capital position of a Company
1. Healthy and unhealthy working capital position can be generalized only according to the industry and sector an entity is operating in. Some entities by nature have higher liquidity and some low;
2. Higher liquidity is not always favourable as it may indicate under-utilisation of resources and money. You will need to further dig in to find if this is the case;
3. Consider recent sale, purchase, construction of an asset, pre-closure of loan or liquidation of a big liability owing to strategic decisions that affect liquidity tremendously;
4. Change in trade terms, seasonal nature of goods sold also has a strong bearing on liquidity position.
Working capital management is extremely important for companies.
It is the main determinant in the liquidity position of a company.
Profitable companies can go bankrupt due to a paucity of liquidity.
