12.5 Working capital ratios Flashcards
What is “current ratio”?
The ratio of current assets to current liabilities.
Why is a current ratio of less than 1 problematic?
It indicates liquidity issues as current liabilities are greater than current assets (a 2:1 ratio is ideal).
What is “quick ratio”?
[Current assets - inventory] / current liabilities
i.e. same as current ratio, but excluding inventory because this cannot be easily converted into cash.
What are the four main efficiency ratios?
1 Asset turnover
2 Inventory turnover
3 Receivables turnover
4 Payables turnover
How is asset turnover ratio calculated?
= revenue / net assets
How is inventory turnover calculated?
= cost of goods sold / average inventory
How is receivables turnover calculated?
= credit sales / average recievables
How is payables turnover calculated?
= credit purchases / average purchases
What are some limitations of ratio analysis?
- benchmarks used may be misleading (e.g. comparing against high-performing companies
- seasonal factors or inflation may affect time-series analysis
- ratios are meaningless without industry comparison
- window dressing may manipulate information
How is the length of the working capital cycle calculated?
= receivables days + inventory days - payables days
