Working capital is the liquid capital readily available to the company to carry on with its daily activities. It is the difference in between the existing assets and the present liabilities of a business. To comprehend what is working capital ratio, an appropriate understanding of the present assets and present liabilities is extremely important.
Working capital, occasionally called networking capital or present working capital, is the difference in between current assets and current liabilities. Assuming all the above numbers are in the thousands, working capital in this case is $100,000. Another method to look at this is that there appears to be two dollars offered in present possessions to pay each dollar of current liabilities. The ratio of existing assets to existing liabilities is $200 to $100 or 2 to 1. Many people believe that a ratio of 2 to 1 is good. As a matter of fact, some textbooks use the 2 to 1 ratio as a normal example.
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Present Assets: Current assets are the short term possessions of a company, which are made use of within one year. Cash, receivable, inventory, short term financial investments and pre-paid expenses constitute the existing possessions of a business.
Existing Liabilities: Current liabilities are the short term liabilities of a company, which are settled within one year. Accounts payable, impressive expenses, payable taxes and short term loans constitute the current liabilities of a company.
Let’s take an example of a fictitious business named ‘Tensa International’, to discover how to compute the working capital ratio. Suppose the present possessions of Tensa International are USD 200,000 and the existing liabilities are USD 150,000, then the working capital ratio for Tensa International is determined as current possessions/ existing liabilities, that is, USD 200,000/ USD 150,000, which is 1.33.
Preferably, the working capital ratio ought to be someplace between 1.2 and 2.0. In case of Tensa International, the working capital ratio is 1.33. This shows that its current liquidity position is great. A very high ratio, that is, above 2, shows that the business has actually underutilized existing assets, that is, it is not investing its possessions correctly.
On the other hand, negative working capital, that is, working capital ratio, which is less than one, indicates that the business might not be in a position to fulfill its short term liabilities. It shows that business will certainly not be able to pay its lenders in time. A negative working ratio might also be because of minimizing current possessions. The negative working ratio needs to be examined very intently, as it might show that the sales of a business are dropping and hence, balance dues are shrinking, hence triggering a reduction in the current asset value.
For preserving an ideal ratio, working capital management is really required. Working capital management is an extremely important part of the money management of a company. This is because the investors base their investment choices on a number of ratios, such as working capital ratio, financial obligation ratios, return on equity ratios, ROI ratio and return on possession ratio. For handling its working capital appropriately, a business ought to keep a few things in mind. First of all, the credit duration given to the customers ought to not be too long. This will certainly ensure that the business has enough cash in hand from the recognized sales. Secondly, to increase its liquidity position, the business itself need to request longer credit duration from its suppliers. Third, the level of stock kept by a business ought to not be too low or too high. It should be sufficient enough to reduce the total raw material expenses. Furthermore, cash and money in a bank must be managed, in such a way that cash holding expenses to business are reduced to a fantastic level. These measures will certainly guarantee that the cash conversion cycle of a company is not too long and therefore, the company will certainly have enough working capital in hand at any given time.
An appropriate working capital ratio is important for the smooth performance of a business. A negative ratio can hamper the future financial investments of a company, as the investors might feel that business is not being run efficiently. Unavailability of sufficient liquid capital, which emerges in the negative working capital ratio can often, lead to bankruptcy too.