Working Capital And Current Ratio - 2 Important Measures Of Liquidity And Solvency

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The Balance Sheet is one of the four required financial statements that accountants
prepare for business owners and managers. This statement shows the assets, liabilities,
and the owner's equity (capital).

The balance sheet is a reflection of the Accounting Equation (Assets = Liabilities +
Owner's Equity). The accounting equation is a simple-minded equality. It informs the
reader of the balance sheet to whom the assets (left side of the equation) belong: the
creditors (liabilities) and the owner (owner's equity).

So, in all businesses, the two parties that can claim ownership of the assets are
creditors and the owner. And in the case of a corporation 'the owner' will be many and
are called shareholders.

What is a classified balance sheet?

A classified balance sheet contains two important sections: Current Assets and
Current Liabilities. For accountants, the word 'current' means in general: one year. In
the case of current assets it means that these assets will be used or converted into cash
during the current fiscal year. In the case of current liabilities, it means that this type
of liabilities will have to be paid during the current fiscal year.

By matching the current assets and the current liabilities accountants derive two
important measures of financial strength; especially, in measuring liquidity (the ability
to pay maturing obligations):

1. Working Capital is the excess of current assets over current liabilities.

WC = CA - LC
$150,000 = 180,000 - 90,000
The working capital ($150,000) is given in dollars.

2. Current Ratio is the ratio we find when we divide the current assets by the current
liabilities.

CR = CA/CL
CR = $180,000 ÷ $90,000
CR = 2:1

The current ratio 2 simply means that for every dollar the business owes in current
liabilities, it has 2 to pay them with. A well-run business will strive to have a CR that
is equal to 2 (or in its full expression 2:1).
As we can see from the above illustrations, the working capital gives the reader a very
limited insight into the strength of the company. $150,000 might be large to a very
small business, or small to good size business. In all cases the WC must be positive. A
company with a very small or negative working capital might find it hard to carry out
its day to day activities.

The current ratio is a more universal measure and it allows accountants and business
people to compare its current ratio with other companies. If the ratio is in the vicinity
of 2 (let's say 1.98 or 2.12), then we can rest assured that we are doing a good job in
managing the business.

If the current ratio is low (let's say 1.15), then it's time to either sell some non-current
assets or obtain a long term loan.

Brief exercise:

If a company's balance sheet shows $180,000 in current assets, and it owes $60,000 in
current liabilities --what is its working capital? What is its current ratio?

If you computed $120,000, and 3:1, respectively, then you've mastered these two
concepts.

Retired. Former investment banker, Columbia University-educated, Vietnam Vet
(67-68).
For the writing techniques I use, see Mary Duffy's e-book: Sentence Openers.
To read my book reviews of the Classics visit my blog: Writing To Live

				
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