Question

10. If you are in charge of the working capital management of a small, local business, name 4 ratios would you be most concerned about and why?

Answer 1

The four ratios would be:

1) Current ratio given by Current Assets/Current liabilities.this

This ratio indicates the ability of the firm to meet its short term obligations in terms of current liabilities. The ratio should be atleast 2, indicating that the current assets is twice the current liabilities. Then it would be a comfortable position. However, the ratio should be compared with industry standards.

2) Quick ratio = (Current assets less inventories and prepaid expenses)/Current liabilities. The ratio is a more stringent measure of the short term liquidity, as it excludes the less liquid items of inventories and prepaid expenses.

The ratio should be at least 1, indicating that the quick assets are equal to current liabilities. Such a position indicates good safety as the current liabilities can be met easily in entirely if need arises.

3) Average collection Period:

This gives the number of days sales in the Accounts Receivable. It is calculated as (Average receivables*365)/Net sales.

The ratio gives the number of days required for collection of a credit sale on an average.

This should be compared with the credit period allowed. If it is more than the credit period allowed the credit and collection policy should be reviewed.

4) Days sales in inventory;

Calculated as (Average inventory*365)/Cost of goods sold, it gives the number of days for which inventory is stocked in relation to its rate of sale.

If it is high, it indicates excessive investment in inventory, which entails avoidable cost.