Working Capital is a measure of a company’s managerial expertise while simultaneously providing a report on its short-term financial health.
The working capital ratio indicates whether a company has enough short-term assets to cover its short-term debt.
There are measurements available to measure the effectiveness of the company’s fiscal management.
The Current Ratio (CR) is the tool used to determine short-term financial strength. The formula is simple and is found by dividing the Current Assets (CA) by the company’s Current Liabilities (CL)
CR = CA / CL
Interpreting the Current Ratio
The results of a company’s current ratio typically should be in a range of 0.0 to 2.0+ and is interpreted as follows.
Ratio of < 1.0 Indicates negative working capital with potential
Ratio between 1.2 & 2.0 The company has sufficient working capital to successfully conduct financial business transactions.
Ratio of > 2.0 Although not as serious as negative working capital, a ratio greater than 2.0 indicates that there is potential to use additional assets to create more revenue.
Effects of Changes in Working
The company’s projects require investment be it equipment, facilities, or other resources. These investments reduce cash flow.
Likewise, there are other activities that can affect cash flow if not managed properly, i.e., collections from sales (Accounts Receivables Outstanding) or payables to suppliers (Days Payable Outstanding).
These two financial ratios are usually calculated quarterly or yearly depending on the length of these time periods.
The Bottom Line. Working Capital is a measure of a company’s short-term financial health. The Current Ratio (CR) is used to determine short-term financial strength and is found by dividing the Current Assets (CA) by the company’s Current Liabilities (CL). Changes in working capital affect cash flow such as investments, receivables or payables outstanding.
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