Financial statement users calculate ratios as a way of evaluating the performance of a company. Ratios allow users to pull selected numbers from the financial statements, perform calculations and measure the effectiveness of the company’s activities. Liquidity ratios, such as the working capital or the current ratio, demonstrate the company’s ability to meet its current payments. Liquidity measures how near a company’s assets are to converting into cash. Many users focus on the balance sheet, paying particular attention to working capital and its composition.
Working capital management determines the success or failure of a business. To continue operating, companies need to make their current payments on time. Businesses pay their current obligations out of their current, or liquid, assets. Financial statement users want to see a company that can pay its bills on time. Working capital analysis allows users to determine how well the company can meet its current obligations.
Working Capital Calculation
Two calculations exist for analyzing working capital. The first calculation looks at total working capital dollars. The user starts by finding the total current asset and the total current liability numbers from the balance sheet. The user calculates total working capital dollars by subtracting the current liabilities from the current assets. The user calculates the current ratio by dividing the current assets by the current liabilities.
The composition of current assets influences the validity of the working capital calculation. Current assets fall into two categories. Some current assets are highly liquid, like cash or short-term securities. Other current assets, like inventory or accounts receivable, take longer to convert into cash. The longer an asset takes to convert to cash, the less liquid it is and the lower its ability for use when paying current liabilities.
The composition of current liabilities also influences working capital validity. Companies meet their current liabilities by paying cash or by providing products or services to customers. Current liabilities that require products or services to satisfy hold minimal impact on the company’s cash needs. Current liabilities that require cash payments, such as accounts payable, make a bigger impact on working capital.