Working capital management – is the management of current liabilities and current assets. In order to operate and generate cash flow to meet the obligations need for short-term and daily operational expense, the proper management of working capital is required.

Working Capital:

There are two concepts of working capital viz .quantitative and qualitative. Some people also define the two concepts as gross concept and net concept.

According to quantitative concept, the amount of working capital refers to ‘total of current assets.  According to qualitative concept the amount of working capital refers to “excess of current assets over current liabilities.

Working capital is a common measure of company’s liquidity, efficiency and overall health. WCM focuses on areas such as inventory and managing accounts receivable/payable.

Another method of determining the performance of WCM is the use of ratios, such as working capital ratio, inventory ratio, and collection ratio. These ratios are used in WCM to determine the weaknesses and strengths of an organization.

Current Ratio:

Working capital management –  The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off its short-term liabilities with its current assets. The current ratio is an important measure of liquidity because short-term liabilities are due within the next year.

This means that a company has a limited amount of time in order to raise the funds to pay for these liabilities. Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that companies with larger amounts of current assets will more easily be able to pay off current liabilities when they become due without having to sell off long-term, revenue generating assets.

The current ratio is calculated by dividing current assets by current liabilities. This ratio is stated in numeric format rather than in decimal format. Here is the formula:

[Current Ratio = Current Assets / Current liabilities]

Breaking down ‘Current ratio’ :

The current ratio helps investors and creditors understand the liquidity of a company and how easily that company will be able to pay off its current liabilities. This ratio expresses a firm’s current debt in terms of current assets. So a current ratio of 3 would mean that the company has  times more current assets than current liabilities.

The ideal current ratio is 2: 1. It is a stark indication of the financial soundness of a business concern. When Current assets double the current liabilities, it is considered to be satisfactory. Higher value of current ratio indicates more liquid of the firm’s ability to pay its current obligation in time.

A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make current debt payments.

If a company has to sell of fixed assets to pay for its current liabilities, this usually means the company isn’t making enough from operations to support activities. In other words, the company is losing money. Sometimes this is the result of poor collections of accounts receivable.

The current ratio also sheds light on the overall debt burden of the company. If a company is weighted down with a current debt, its cash flow will suffer.

Quick Ratio or Acid Test Ratio:

The acid test ratio is a stringent and meticulous test of a firm’s ability to pay its short-term obligations ‘as and when they are due. Quick assets and current liabilities can be associated with the help of Quick Ratio.

The ideal Quick Ratio is 1: 1 and is considered to be appropriate. High Acid Test Ratio is an accurate indication that the firm has relatively better financial position and adequacy to meet its current obligation in time.

Absolute Liquid Ratio:

The relationship between the absolute liquid assets and current liabilities is established by this ratio.

Absolute Liquid Assets take into account cash in hand, cash at bank, and marketable securities or temporary investments. The most favourable and optimum value for this ratio should be 1: 2. It indicates the adequacy of the 50% worth absolute liquid assets to pay the 100% worth current liabilities in time. If the ratio is relatively lower than one, it represents the company’s day-to-day cash management in a poor light. If the ratio is considerably more than one, the absolute liquid ratio represents enough funds in the form of cash in order to meet its short-term obligations in time.

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Sneha is a full-time writer at Nvestweekly and is passionate about Blockchain Technology. Leveraging over three years of experience in media, she covers the daily developments in the crypto ecosystem.

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