Working Capital Management Ratios
The working capital ratio (also called the current ratio), the collection ratio, and the product turnover ratio are three keys to managing working capital.
1. Current Ratio (Working Capital Ratio)
To find the current ratio, or working capital ratio, divide the current assets by the current obligations. The current ratio shows how well a company can meet its short-term financial responsibilities and is a key indicator of its financial health. When a company’s working capital ratio is less than 1, it usually means it might have difficulty meeting its short-term commitments. That’s because the business has more short-term debt than short-term assets. The business might have to sell long-term assets or get money from outside sources in order to pay all of its bills when they’re due. People like working capital ratios between 1.2 and 2.0, which means the company has more current assets than current obligations. A number higher than 2.0, on the other hand, could mean that the business isn’t using its assets well enough to bring in more money. As an example, a high ratio could mean that the business has too much cash on hand and could be investing that money more wisely in growth possibilities.
2. Collection Ratio (Days Sales Outstanding)
This number, which is also called “days sales outstanding” (DSO), shows how well a business handles its accounts receivable. To find the collection ratio, multiply the number of days in the time by the average amount of accounts receivable that are still due. After that, this item’s value is split by the total amount of nett credit sales during the reporting period. Most of the time, companies just take the average between the beginning and closing balances to find the average amount of revenue they are owed. Based on the collection percentage, you can find out how many days it usually takes for a business to get paid after selling something on credit. The days sales outstanding number does not take cash sales into account. If a business’s billing department is good at getting past-due accounts, the business will get cash faster and be able to use it for growth. On the other hand, if a company has a long outstanding time, it means that it is giving short-term loans to creditors without charging interest.
The product turnover ratio is another important measure of how well you are managing your working capital. For a business to be as efficient as possible, it needs to keep enough goods on hand to meet customer needs. But the business also needs to keep costs and risks as low as possible and avoid keeping too much product on hand. The cost of goods sold divided by the average amount of inventory on hand gives you the inventory turnover ratio. As we saw before, the average balance in inventory is generally found by dividing the beginning and ending balances by two. When a company looks at this percentage, it can see how quickly its stock is sold and replaced. If a company’s ratio is low compared to others in the same industry, it could mean that its stockpile levels are too high. To lower the costs of insurance, storage, security, and theft, it may want to slow down production. On the other hand, a fairly high ratio could mean that there aren’t enough items in stock, which could affect customer happiness.