Investors are very keen to know about the financial health of a company by evaluating financial statements. They have a closer look at the liquidity, asset utilization, and capital structure of company. Managerial efficiency is very important for proper working of these categories named above.

Unbiased Facts and Analysis

Working capital shows relationship between current assets and current liabilities. It is a difference of both current assets and current liabilities and is expressed in dollars. It is not relevant to the firm’s liquidity evaluation even it is not mentioned in the financial reports. It highlights firm’s liquidity to some point regardless of its size. Also note that current ratio, acid test ratio or called as quick ratio they do not sufficiently present an evaluation to investors about company’s liquidity. Current ratio shows liquidity of current assets over current liabilities. It is a time that company requires to convert an asset into cash. Company operates on a going concern assumption. It is not set up for a day, month or a year. Its life is unlimited. It will continue to run and operate in future. To evaluating company’s liquidity relying on current ratio will be misleading.

Liquidity Measurement

Current ratio tells us about the operating cycle efficiency. It also highlights company’s liquidity. Liquidity is the ability to immediately convert current asset into cash. Companies with bad performance of collecting receivables, and low inventory turnover face difficulties and problems of liquidity. This would lead a company to face huge burden of obligations and problems in lightening this burden can occur. Operating activities of all companies vary from each other, so it is important that comparison of companies must be made within same industry.The Current assets and current liabilities are the components of current ratio. They can be used to originate working capital equation. It is the difference between current assets and current liabilities. Working capital ratio is frequently derived by using Working capital. The working capital refers to the amount exceeding current assets over the current liabilities. Simply it is difference current assets and current liabilities expressed by following equation.

Working Capital = Current Assets – Current Liabilities

A company with Positive working capital means can meet its short-term liabilities. While with Negative working capital Company is unable to meet or pay off its short-term liabilities. It has liquidity problems and it is unable to convert current assets i.e. accounts receivable and inventory into cash.

Cash conversion cycle consists of following activity ratios

• Inventory Turnover ratio
• Accounts receivables turnover ratio
• Accounts payables turnover ratio

They can be expressed in times of per year or days. It is expressed as under:

Cash Conversion Cycle = Inventory Turnover days (Cost of Goods Sold/365) + Accounts receivables turnover days (Net sales/365) + Accounts payables turnover days (cost of sales / 365)

Liquidity Shortfall

Company can face lot of problems if it is short of cash. Companies in losses can operate but without cash they can not do so. With cash companies can enter into new line of business or can avail new opportunities. Operating cycle or cash cycle truly measures liquidity.

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