Working capital is the main financial driver that allows a business to meet its current obligations and continue operating. Calculating the amount of working capital is very simple. Investigating the components and application of working capital creates a deeper understanding regarding the viability of a business and the soundness of its future.
The working capital you have available to you will be equal to the difference between your current assets and current liabilities. Current assets are cash, cash equivalents and anything convertible to cash within one year’s time. Current liabilities are debts due within one year.
A useful measure of liquidity (a measure that shows the business has enough current assets to keep operating smoothly) is the current ratio. Calculate the current ratio by dividing the total current assets by the total current liabilities.
This is useful because, no matter what the scale of an organization is, the relationship between total current assets and total current liabilities is revealing of the company’s financial condition.
For example, a company with $125,000 in total current assets and $100,000 in total current liabilities would have a current ratio of 1.25 (125,000 ÷ 100,000). Similarly, a company with $125,000,000 in total current assets and $100,000,000 in total current liabilities would have a current ratio of 1.25 ($125,000,000 ÷ $100,000,000).
Even though the scale of the organizations given in the example is very different, the relationship between current assets and current liabilities is the same. One rule of thumb used in financial accounting and analysis is that a current ratio over 1.25 means, barring any unforeseen circumstances such as fraudulent accounting or mistakes in reports, the company is in a good financial position.
A company that cannot meet its current obligations will have a current ratio of less than one and is in financial trouble. Unless the company can get more cash, it will likely go out of business soon.
The working capital turnover ratio shows how efficiently a firm is using the working capital to generate business. You can find this ratio by taking your net annual sales and dividing by the average level of working capital. A low ratio means the use of capital is inefficient, while a high ratio indicates excessive trading that could put the organization at risk of running out of capital.
Businesses need working capital to expand operations and capture market opportunities. If there is not enough working capital available, businesses are not reaching their full potential. One way to increase working capital is to use business financing strategies, which include taking a working capital loan and equipment financing.
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