Cover Image
close this bookFinancial Management of a Small Handicraft Business (Oxfam, 1988, 43 p.)
close this folderIII. The concept of working capital
View the documentIII.1. Defining working capital
View the documentIII.2. The role of working capital
View the documentIII.3. Performance measurement
View the documentIII.4. Profits

III.3. Performance measurement

(i) Ratio analysis

The working capital position of an enterprise can be interpreted from a balance sheet by a method known as ratio analysis.

In Figure 8 the current assets of Fibre Mat Society total 90,000. Current liabilities are 70,000. These figures may be expressed as a ratio:

Current ratio = ( Current assets ) / (Current liabilities ) = 90 000 / 70,000 = 1.29:1

The current ratio gives an initial measure of what is called the liquidity of a business. This means the extent to which its current liabilities are covered by cash, or assets able to be converted quickly into cash. It is clear that a current ratio of less than 1:1—meaning that current liabilities exceeded current assets—would be extremely dangerous. Generally, it can be said that an enterprise needs a current ratio of 1.5:1 minimum, and better 2:1. It would appear that the Society has a liquidity problem.

A second working capital ratio looks at the situation a little more critically. This is the quick ratio, or acid test, in which stocks are omitted from the current assets.

Acid test = ( Current assets - stock ) / (Current liabilities ) = 50 000 / 70,000 = 0.71:1

This ratio assumes that if an enterprise had to raise cash very quickly to meet liabilities, it would be able to convert debtors more quickly than stock. The usefulness of the ratio rather depends on the validity of this assumption. For comfort, the acid test should yield a ration of 1:1. The poor ratio of Fibre Mat Society confirms a disturbing situation.

(ii) Limitations of ratios

Like all financial statements, ratios have to be evaluated with care. In the first place, the balance sheet describes the situation at one point in time only, here 30 September 1986. Stocks might be high because the Society is building them up for the peak selling season. A figure which might be unacceptable at one time of year could be less worrying at another.

Apart from the question of seasonality, some standards are required by which to evaluate the situation. The most informative measures are the past financial statements of the business. In comparing what has happened between two balance sheets, it is possible to see if the present situation represents an improvement or a deterioration in performance.

The major shortfall of ratios is that they say nothing about the quality of assets held. Is the stock good, will its value hold, can it be sold quickly? Or does the high figure of finished goods suggest dead stock, overvalued in the books? Are the debtors safe, will they all pay, and when? Further information is also required about the liabilities: What is the Society's overdraft ceiling? How much time will the creditors allow?

In other words, liquidity ratio analysis might signal whether there seems to be a working capital difficulty: but it is only the starting point for looking more closely at the component parts of working capital, for bringing judgement to bear on the true nature and extent of the problem, and for identifying what should be done to improve things.