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Understanding the Use of Financial Ratios in Management of Working Capital

By Edited Dec 4, 2016 0 0

Managing the working capital of a business entity is a multi-faceted responsibility. Not only must a manager keep track of the financial health of a company by using financial ratios, but they must also understand appropriate cash management strategies and how they may impact the delivery of services, collection of cash from customers and payments to suppliers.

• Financial Ratios and Industry Standards

Liquidity and efficiency ratios such as current ratios, quick ratios, cash conversion cycle, inventory period, receivables period and payable periods are financial tools used to gauge the health of a business with respect to their ability to work with their cash. These tools are most useful when comparing a company to industry averages or a strong competitor's position.

• Current Ratio

If the current ratio for a given industry is 1.66 and a given company's current ratio is 3.5, this would indicate that the company has an above average ability to convert their current assets to cash quickly at a relatively low cost. Therefore, a higher current ratio is better than a lower current ratio.

• Quick Ratio

If the quick ratio for a given industry is 1.24 and a given company's quick ratio is 1.1, this would that indicate that the company has a lower than average ability to become liquid quickly. Therefore, a higher quick ratio is better than a lower quick ratio.

• Working Capital Strategies

Current assets, long term assets and current liabilities are known as working capital. Current assets include cash and marketable securities, accounts receivables and inventory. Current liabilities include short term financing such as short term loans, accounts payables and current liabilities such as accrued income taxes and current payments on long-term debt. To evaluate the working capital of a given business, it is useful to calculate the cash conversion cycle of the business as follows:

Calculation of Cash Conversion Cycle

In other words, it will take the company an average of almost six months (171.5 days) from the time they lay out their money for inventory until the time they collect payment from their customers. Therefore, higher cash conversion cycle numbers are better than lower cash conversion cycle numbers.

It is important to monitor the cash conversion cycle because it is an indication of how much of a cushion a company has to carry themselves through tough times. When the number is low, a manager can reduce the average inventory, decrease the accounts receivable period or increase the accounts payable period to conserve cash.

In theory, the math is simple. However, the strategies to improve the cash conversion cycle must be carefully weighed against the possible impacts to the business. Juggling inventory can have an impact on services or goods delivered to a customer. Decreasing the accounts receivable period may strain relations between the customer and the company. Increasing the accounts payable period may strain relations between the suppliers and the company.

Therefore, managing the working capital of a business entity is not only about tracking the ratios. The manager must also be able to carefully weight and balance the potential impacts to the company's customers and suppliers and still keep the company is a strong financial position.

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If you are looking for more information on business management, you might be interested in some of the other articles I've written:

How to Create an Effective Performance Appraisal System, Qualities of an Effective Leader, Understanding the Concept of Opportunity Cost, Basics of How to Counsel an Employee for Improper Behavior, Understanding the Basics of Cost Accounting, Understanding the Importance of Organizational Behavior



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