Investors judge a company by using various methods to know whether a company has adequate working capital. In this regard, current ratio is more useful than the net working capital. Current ratio (CR) is calculated by dividing current asset (CA) by current liabilities (CL).
CR = CA / CL
What is Current Assets and Current Liabilities
To classify a particular asset as current asset (CA), you first have to find out entity’s operating cycle.
Company’s operating cycle is the average number of days within which the entity put cash into the business operation and then convert it back to cash.
Current asset includes cash, bank balance, accounts receivable, marketable securities, inventory and others which can be turned to cash within one year or within the operating cycle of the business.
Current liabilities (CL) includes accounts payable, wages or salaries outstanding, income tax payable and others which has to be paid within one year or within the operating cycle of the entity.
Analysis of Current ratio (CR)
One of the main reason to assess company’s liquidity position is to know how it can manage its short term obligations in case of financial difficulties. If current liabilities are rising faster than liquid assets, then CR will fall, falling CR shows that company will have difficulties in paying claims of short-term creditors. This ratio is most commonly used to assess company’s short-term solvency.
Ratio of 2 to 1 generally considered as good. This means CA should be twice of CL. If it’s less than 1, then it indicates that the entity has no capital on hand to pay all short term obligations at once. Similarly, greater than one indicates that the entity has enough capital to take care of short term dues.
Another way to judge adequacy of working capital is to find out company’s quick assets ratio, sometimes referred to as the acid test.
To find quick asset ratio, you need to divide quick asset by current liabilities. This means there is no change in denominator. It indicates the liquidity position of a company.
Quick assets are those assets which can be quickly and easily convertible to cash. These are highly liquid. To find it out, you need to take out inventories and any other illiquid assets from CA. It includes, cash and bank balance, marketable securities and accounts receivables.
Cash and bank balance includes physical cash in hand, bank balance in various accounts and interest bearing investments like Fixed Deposits, Recurring Deposits and other instruments.