ACCOUNTING TUTORIALS
Part 2: The Basics of Interpreting Financial Statements
Understanding Working Capital and Liquidity Measurements
Liquidity is a firm’s ability to meet its current obligations. This is measured by the relationship of its current assets and current liabilities as shown on the balance sheet.
Working capital is the excess of a firm’s current assets over and above its current liabilities.
Remember:
Current assets are cash and other assets that are likely to be converted into cash within 1 year. (In most cases, this means accounts receivables and merchandise inventory.)
Likewise, a current liability is an obligation that is likely to be paid within one year. Current liabilities include:
Loans
Accounts payables
Accrued interest and wages
There are three primary methods for measuring liquidity:
Working capital = current assets – current liabilities
Current ratio = current assets / current liabilities
Acid-test ratio (quick ratio) = cash + accounts receivables / current liabilities
Notes:
By itself, the dollar amount of a company’s working capital doesn’t really tell you much. If you know, for example, that a company has a working capital of $200,000, you still have a lot of questions. Is $200,000 a lot of money? It depends…
The current ratio is more useful, especially if you can look at it at several points over time (in other words, the trend). This gives you an idea of a company’s ability to pay its obligations----a useful measurement when determining whether or not to extend credit.
The acid-test ratio, unlike the current ratio or working capital measurement, excludes merchandise inventories. Why could this distinction be important? Well, suppose that a firm’s products aren’t selling---or the economy has taken a downturn. The acid-test ratio gives you an idea of how the company will fare if Murphy’s Law prevails.