Prepaid expenses can’t be accessed immediately to cover debts, and inventory takes time to sell. However, positive net working capital isn’t necessarily always a net positive for your company’s competitive, operational, and financial health. If you find yourself swimming in extra cash, it’s likely you’re not investing your liquid assets as strategically as you might and are missing out on opportunities to grow, produce new products, etc. On the flip side, when companies depend on credit lines and loans, it can lower their ratios. This is because they obtain assets from creditors only they need to settle outstanding liabilities, reducing net working capital. In the end, the value of a working capital ratio is only as good as the company’s accounts receivables, credit, and inventory management.
The common financial ratios every business should track are 1) liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios. Say a company generates $900,000 in net sales but requires $800,000 of resources to do it while another company can generate the same amount of revenue by using $400,000 in resources. In this example, the company that is better at cutting expenses will have a higher return on sales ratio and, therefore, be more profitable and attractive to potential investors.
Why look at financial ratios?
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Current assets, such as cash and equivalents, inventory, accounts receivable, and marketable securities, are resources a company owns that can be used up or converted into cash within a year. Since the working capital ratio measures current assets as a percentage of current liabilities, it would only make sense that a higher ratio is more favorable. This means that the firm would have to sell all of its current assets in order to pay off its current liabilities. The working ratio is not perfect and cannot be fully relied on to determine a company’s financial health and ability to cover expenses with the money it brings in. Financial ratios are good key performance indicators used to measure a company’s performance over time compared to competitors and the industry.
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Generally speaking, having a ratio between 1 and 3 is ideal, but certain industries or business models may operate perfectly fine with lower ratios. Within the current ratio, the assets and liabilities considered often have a timeframe. For example, liabilities in this ratio are usually due within one year. On the other hand, current assets in this formula are resources the company will use up or liquefy (converted to cash) within one year. Working capital management demands coordinated actions and strategies for optimal inventory and accounts receivables as one part of the company’s liquidity. For instance, even if a company has a net working capital of 1.8, it can still have a slow inventory turnover or slow collection of receivables.
Generally speaking, high cash to working capital ratio implies that the company is more liquid and can pay off its short-term obligation without struggling. In contrast, a low ratio is an indicator of difficulty in supporting short-term debts due to less cash and cash equivalents. Negative working capital, on the other hand, means that the business doesn’t have enough liquid assets to meet it current or short-term obligations. This is often caused by inefficient asset management and poor cash flow. If the business does not have enough cash to pay the bills as they become due, it will have to borrow more money, which will in turn increase its short-term obligations. Since a company’s expenses and revenue could vary over time, higher revenue might not be the best indicator of a company’s profitability.