Current Ratio

 

Working capital is not the factor which will make difference in between two companies but still working capital is important.

What is working capital technically?

Current Asset minus current liability.

What is included in current assets?

Cash and Cash equivalents, Inventory, Account receivables, Prepaid expenses, bank balance, Short-term investments, Tax advances, Short-term loans given to vendors.

What is included in current liability?

Creditors ( Account Payables), Short-term borrowings ( Most of the time they are bridge finances or working capital loans from banks or loans received from suppliers) Accrued expenses, advances from customers ( many times thought as GOOD Liability, bills discounted.

So what is important in current ratio?

in simple word Current ratio is telling you that if all of its creditors came tomorrow and ask money immediately will company in a position to pay?

This ratio is not something which can make a large difference in between two companies but if not handled correctly it can make a large difference by forcing the company to depend on Borrowed funds for all small payments.

From formula its clear that Current ratio below 1 is not good as the company maybe not in a position to pay its Accounts payable. Not good for the company. In such cases generally, I always checked Debt to equity and Interest coverage ratio.

A ratio of 1 to 2 ( some may say 3 ) shows a good sign that there are sufficient funds for the company to pay its accounts payable.

Above 2, Capital is not handled correctly. Such companies tend to be low Return on Equity.  The best way in such cases is to buyback or dividend. 

The quality of the ratio is also one concern. Like if High Current ratio and low Quick ratio indicated that Inventory is sufficiently high. maybe the company is failed to generate revenue. Asset turnover ratio plays key role here. Some business is to be ignored here. Like sugar. In India sugarcane is not harvest all year. So companies tend to produce sugar at the certain time period of the year and sell it for the whole year.

Advances from customers most probably thought as good as you received the cash and running your business with help of the cash.

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About Ashutosh Tilak

Tracking Indian Capital Market since 2010. Finance Student, On this blog I am writing about finance and Investing. You can contact me analystashu@gmail.com or @androidashu & @InsideFinanc on twitter