Question

Finanical analysis pays particular attention to company liquidity.

What factors would influence your decision as to whether a current ratio is "good" or "bad"?

Suggest several reasons why a 2:1 ratio might not be sifficient for a particular type of company.

Why is working capital given particular attention in the analysis of balance sheets?

Answer 1

1. Financial analysis is used to analyse whether an entity is stable, solvent, liquid, or profitable enough to warrant monetary investment.One of the most common ways to analyse financial data is to calculate ratios from the data in the financial statements to compare against those of other companies or against the company's own historical performance.

2. For liquidity analysis, calculate the company's current ratio.

​Current Ratio=Current liabilities÷Current assets​​
The current ratio shows how many times entity can pay its current debt obligations based on its current assets.The current ratio reveals your business's ability to meet its current obligations.It is an indication of a firm’s market liquidity and ability to meet creditor’s demands.

Current assets include cash, accounts receivable, inventory and other assets that are expected to be turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt.
If current liabilities exceed current assets i.e., the current ratio is below 1, then the company may have problems meeting its short-term obligations. If the current ratio is too high, the company may be inefficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management.

A current ratio that is in equal to the industry average or slightly higher is generally considered acceptable. A current ratio that is lower than the industry average indicate a higher risk of default.

3. Generally, current ratio of 2:1 or higher is considered satisfactory for most of the companies.
Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio is not always be a green signal.


A company with high current ratio may not always be able to pay its current liabilities, There may be problem in recovering its dues from its debtors and the debtor cycle is negative.Debtors may be large due to delays in payment and that may be the reason for a high current ratio.
On the other hand, a company with low current ratio may be able to pay its current obligations as they become due if a large portion of its current assets consists of highly liquid assets i.e., cash, bank balance, marketable securities and fast moving inventories.
It depends upon the type of business you run, if your business has enough income to pay all current liabilities you don’t have to use the 2:1- you could use 1:1.


4. Working capital=Current assets-Current liabilities
Working Capital Management requires monitoring a company's assets and liabilities to maintain sufficient cash flow.Working capital management helps maintain the smooth operation of the net operating cycle, also known as the cash conversion cycle i.e. the minimum amount of time required to convert net current assets and liabilities into cash.
It is important to analyze firm's working capital because it is a signal of a company’s operating liquidity.


If current assets > current liabilities, positive working capital
If current assets < current liabilities, negative working capital

The goal of working capital management is to maximize operational efficiency.Managing working capital means managing inventories, cash, accounts payable and accounts receivable.Efficient working capital management helps maintain smooth operations and can also help to improve the company's earnings and profitability.