Working capital is the term given to the assets a business uses to fund its day to day operations.
Working capital ratios provide a way to quantify how effectively a business manages its working capital, and a means to compare against trend, plan, industry benchmarks, or competitors.
The current ratio looks at the relationship between current assets (stock, debtors, cash) and current liabilities (trade creditors, tax liabilities, bank overdraft e.t.c.).
A ratio of between 1.5:1 and 2:1 is generally considered optimal, although many businesses these days are able to work within a ratio of 1:1.
The quick ratio is similar to the current ratio but offers a more precise measure of liquidity. It is calculated as (current assets – stock) / current liabilities. It may take time for a business to turn stock into cash, so by excluding stock from the calculation, the quick ratio offers more insight into the liquidity of a business.
When assessing the working capital position of a business, it is normal to consider both the current and (for businesses that carry stock) quick ratios.
Cash conversion cycle
The cash conversion cycle expresses the time (in days) it takes on average for a company to convert its stock and other resources into cash flows from sales. This takes into account how much time the company takes to i) sell its stock, ii) collect money due from customers and iii) pay its suppliers.
Monitoring the trend in a business’s cash conversion cycle over time provides useful insights about whether operational efficiency is improving or deteriorating. A decreasing cycle is generally a good sign; an increasing cycle warrants further investigation.
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