Question

How can Working Capital be used to assess the company's liquidity performance? justify your answer with Example. Explain in 300 or more Words .

Answer 1

Working capital can be defined as the day to day operative capital of the company. It is calculated by subtracting the current liabilities from the current assets of the company.
Liquidity means the availability of liquid assets in the company. A liquid asset can be defined as cash and cash equivalents which can be readily be converted to cash easily.

Working capital is a good measure of a company's liquidity. It indicates how well is the financial health of the company is during the short term. A positive working capital is considered as a marking for having the potential for investment and growth for the future investors. The working capital symbolises that a company has sufficient liquidity. It indicates that the current assets are adequate to cover up all the current liabilities of the company. This indicates that the current assets are sufficient to pay off the current liabilities without any outside help. This shall give an assurance to the potential investors that their investment is in safe hands.

Let us take an example for better understanding,
Suppose a company has a current assets of $10,000 and current liabilities of $4,000.
The working capital shall be Current assets less current liabilities
= $10,000-$4,000
= $6,000

If the current assets increased to $11,000
then the working capital shall be= Current assets- current liabilities
=$11,000-$4,000
=$7,000

This means that if the company's working capital increases its liquidity also increases. The liquidity flow is directly related to the working capital of the company. If the company's working capital increases; the liquidity of the company also increases; whereas if the working capital decreases the liquidity decreases as well. A good liquid position is an indicator of the good financial health of the company. Therefore the analysis of the working capital can give a detailed indication of the financial liquidity of the company.