Financial management is an important part of an organization, in fact, like other key functions of the business, sound financial management ensures that the business is aware of the trends and opportunities for its success. Business shareholders use ratios to measure the financial performance of other businesses and make judgments in regards to management effectiveness. In this unit, based on the reviews of the financial ratios and trend analysis, a discussion on three questions on current ratio and working capital will be undertaken.
1. What three factors would influence your evaluation as to whether a company’s current ratio is good or bad, why?
The current ratio is liquidity ratio which measures the company’s ability to repay current liability with current assets. The current ratio measures the financial strength of the business as stated by Auerbach (1995, p. 10). Thus the three factors that would influence my evaluation to whether the company’s current ratio is good or bad are:
a) Turnover rate of assets which is a ratio indicating the efficiency of deploying assets to generate revenues. Thus, when a company has high asset turnover ratio is efficient in generating income using the assets according to Peavler (2017);
b) The composition of current assets is an important factor to consider because when the current assets account is composed of liquid assets which are fast-moving assets then the company is able to generate revenues faster. Also determining the current ratio of the business if it is less than one it will be indicating that the company may have challenges to meet its obligations thus the current ratio would be bad. However, if the current ratio is greater than one that is a good current ratio;
c) The type of business can help understand whether the current ratio is good or bad in the sense that small businesses, for example, can operate with a current ratio less than one. If the inventory turns into cash quickly than the accounts payable become due, thus the firm’s current ratio can comfortably remain less than one according to https://en.wikipedia.org/wiki/Current_ratio (2017).
However, it is important to mention that current ratio does not demonstrate the whole picture as they have limitations. One of the limitations is when used to compare different companies provided that businesses differ. Also comparing companies in different sectors using current ratio will not lead to accurate result about the financial health.
2. Suggest several reasons why a 2:1 current ratio might not be adequate for a particular company
As discussed above current ratio above one indicates a comfortable status for the business provided that is able to use its assets to generate revenues. According to Agarwal (n.d) current ratio, more than 2 suggests that the company may not be using its current assets efficiently thus if the company has debt coming due in less than 12 months without enough assets able to pay the debt then the company is facing liquidity issues.
A 2:1 current ratio is also not adequate for a particular company because it indicates excessive liquidity although business managers find this status more comfortable to have more than required for normal operations. Thus the company may be sacrificing earning for liquidity this may not be advantageous for shareholders provided that the excess assets are not generating profit according to Sherman (2011, p. 82).
It is important to highlight also that the cash held will limit the company to tap into new business opportunities.
A 2:1 current ratio may not be adequate if the current assets are made up of slow moving accounts by a large percentage.
3. Why is working capital given special attention in the process of analyzing balance sheets?
Working capital is the value remaining after subtracting the current liabilities from current assets. When analyzing the balance sheet working capital is given a special attention because it’s a major factor determining the short-term liquidity position of the company as stated by Kennon (2017).
Business managers and investors are more interested in knowing the financial condition of the business to whether the company is able to operate sustainably or not. High working capital indicates less financial challenges the company will face. However, too much working capital can slow returns and requires management to take immediate action to either investing or distribute some as dividends.
It can be concluded that as businesses strive for sound decision making, financial ratio analysis provide valuable information that supports management for sound decisions as this information measures the financial health of the business and management has to pay attention to the analysis in order to gain the competitive advantage. In the discussion, it has been noted that not always current ratio above one indicates good financial health and not always current ratio less than one indicates that the business is in critical financial status.