Ratios: Working Capital and the Current Ratio - Online Tutor, Practice Problems & Exam Prep

The current ratio is a key liquidity measure, calculated as $\frac{\mathrm{current\; assets}}{\mathrm{current\; liabilities}}$. A ratio above 1 indicates sufficient assets to cover liabilities, while below 1 signals potential liquidity issues. Working capital, defined as $\mathrm{current\; assets}-\mathrm{current\; liabilities}$, reflects short-term financial health. Positive working capital suggests stability, whereas negative indicates potential financial distress. Efficient asset management is crucial for maintaining optimal liquidity.

Ratios: Working Capital and the Current Ratio

Alright, let's discuss one of the most common ratios, the current ratio and a related concept of working capital. So, let's start here with the current ratio. The current ratio is the most common liquidity ratio. When we talk about liquidity, remember, the liquidity of assets is how easily they can be converted to cash. And we're going to be talking about our current assets and our current liabilities here. So, this is basically dealing with being able to cover our current liabilities. So, let's think about it. The current ratio, here we have the formula right here. We have current assets divided by current liabilities. Okay? So remember, current assets are all of our assets that are cash or converted into cash within 1 year. And current liabilities, well, that's money we're going to have to pay out within 1 year. Okay? Liabilities coming due within the next year. So, let's think about what the current ratio tells us. Remember, when we think about a ratio, we're thinking about for each dollar of the bottom number, so for each one unit or $1 of the bottom number, so for each dollar of current liabilities, how many current assets do we have? What do you think? Do you think we would want to have more than $1 of current assets per dollar of current liabilities or less than $1 of current assets per dollar of current liabilities? Well, we would want to have more current assets, right? We would want to have enough current assets to cover our upcoming payments that we have to make, right? These current liabilities are going to be due within the next year. Well, we better have enough money to cover all of those. So that's what we use the current ratio for is to kind of see this relationship. So it tells us how many dollars of current assets are available for each dollar of current liabilities. Cool? So a current ratio below 1.0, right? Below 1, well, it's generally a sign of liquidity problems, right? Because that means you have less than $1 of current assets for each dollar of current liabilities. Okay?

So now that we've discussed the current ratio, let's move on to working capital and you'll see how similar these concepts are. Where working capital really isn't technically a ratio, right? It's not technically a ratio because we're not dividing one number by another. Alright, sorry about that. But it's still a useful financial analysis tool that is still calculated all the time. So working capital, well we're using those same numbers. We're talking about current assets minus current liabilities in this case, right? Before we were dividing the two, well now we're just subtracting the two. And what do you think? Do you think we want positive working capital or negative working capital? We generally want positive working capital, right? We want those current assets to be more than our current liabilities. So when we see positive working capital, well, that indicates short term stability. Right? We're able to cover our upcoming liabilities in the short term. Now, what we're going to see is when we have negative working capital, just like when we have a current ratio under 1, right? A red flag here is if we see negative working capital, well that's going to indicate short term problems, right? Short term financial problems because we're going to see that. We don't have enough current assets to cover up those upcoming liabilities. We might have to sell some of our fixed assets, right? What it might be, we might have to take on more long term debt to take to cover our liabilities. Whatever it is, that negative working capital could be a sign of problems, alright? Also, another thing to think about is if you have some huge amount of working capital, like a really high amount of working capital, it could mean you're inefficiently managing your assets, right? You have just way too many assets for the amount of current liabilities. You could be maybe investing more in fixed assets and your long term assets. Maybe you're just sitting on a bunch of cash and you're not using it, right? The cash isn't making you any money. It's just sitting there. Well, there could be better uses for it, right? So let's go ahead and do an example here and then you guys could practice calculating the current ratio and working capital. So let's start here with the current ratio. And one thing I want to note, whenever you're doing ratio problems, they're generally pretty simple, especially when they come up on a test. These are like free points. All you have to do is remember the ratio and it's as simple as just dividing two numbers or something like that. On a test, you generally don't have to do too much analysis of ratios. It's mostly just calculating. Now if you have some projects in your class where you're using a bunch of ratios and doing financial analysis of a company, well then it might be more important to focus on the analysis side. But as far as test-taking goes, most of it's just as easy as calculating the numbers. So let's try this example. Super Liquid Company has current assets totaling 450,000 and current liabilities totaling 315,000. Calculate the current ratio and working capital for SLC. This couldn't be any easier, right? They told us the current assets, they told us the current liabilities, and you can expect sometimes you get questions that are this easy. How bad would it be to lose points on something like this? So let's go ahead and start with our current ratio. So current ratio, well, remember, we have our current assets. I'll put c for current assets over current liabilities, right? Assets on top, liabilities on the bottom there. And how do we do it? 450,000 divided by 315,000. Not much better there. Well, what's that give us? 450 divided by 315. Right? And you could just do 450 divided by 315. Right? It'll give you the same answer. Take off those zeros. So we get a current ratio of 1.43. I'll round it off to 2 decimals there. So 1.43. Like we saw above, a good analysis point is, are you able to cover your current liabilities and that's to see a current ratio above 1. So this is a good sign that this company is in a position to cover their upcoming liabilities. Cool? Let's go ahead and do working capital now. So working capital, we're using the same data except now we're subtracting, right? It's going to be our current assets of 450,000 minus current liabilities of 315,000, right? And we just do that 450 minus 315 and it gives us 135,000 as working capital. So that means we have in a dollar amount, right? This is a dollar amount right here. It tells us that we have 135,000 more dollars of current assets than current liabilities. Cool? Alright. So that's about it there. Let's go ahead and pause and you guys can try the next one in the practice problem, alright? Let's do that now.

The following table contains selected financial information for Tougher Question, Inc.

Calculate the current ratio and working capital for TQ, Inc.

Alright, let's go ahead and try this question. The following table contains selected financial information for Tougher Question Inc., and it asks us to calculate the current ratio and the working capital, right? But notice that in this question, they didn't just tell us straight up like they did in the example. What are our current assets or what are our current liabilities? We have to go ahead and figure that out for ourselves. So remember that our current ratio and working capital, they both deal with current assets and current liabilities. The current ratio is current assets divided by current liabilities and working capital is current assets minus current liabilities. So we definitely have to go through here and we have to select where our current assets and current liabilities are. So let's go account by account. Cash is our first one, and we know cash is a current asset, right? Because it's already cash and it's going to be cash within 1 year because it's already cash. How about the next one? Machinery. Let's go down the list here. Machinery, well, that's a long-term asset, right? These are fixed assets that we're going to have for multiple years, so that's not a current asset. How about the next one? Accounts receivable. Well, we know accounts receivable are current assets as well, right? A current asset because we're expecting our customers to pay us in the relatively short term. Next one here, short-term debt. Well, when you see the word short term, that should be a signal that we're talking about something current, okay? Whenever it's short term, that means it's a current thing. But what about debt? This isn't a current asset, right? It's debt. It's money we owe. So we're talking about a current liability here. I'll put that one in blue. Let's put our current liabilities in blue. Alright, next, land. What do we think about land? Well, land, it's a long-term asset, right? It's something we're going to use for multiple years. It's not a current asset or a current liability. The next one, accrued expenses. Now accrued expenses are current liabilities as well. Remember we talked about these when we did adjusting entries and we made adjustments for time periods, especially with wage expenses and salaries, things like that. So accrued expenses are current liabilities that we're going to be paying off in the relatively short term. Alright? Let's go on to the other column. Next, we've got inventory. Well, inventory we know is a current asset, right? We're trying to rid of that as soon as possible and get money for it. It's a current asset, we're expecting that to turn into cash soon. How about next? Accounts payable. Well, that is our very first current liability. This is a very common current liability and that is definitely current. This is just money we owe to suppliers, things like that. How about the next one? Common stock. Remember, common stock is an equity account. This is the stock in our company that our shareholders own. That's in the common stock account, so that is equity. That's not a current asset or a current liability. Bonds payable. Bonds payable are long-term debt that we have. We've sold these bonds and we got some money for them and we're eventually going to have to pay them back. Okay? So these bonds payable are generally long term. Whenever you just see bonds payable, you've got to think of it as long term. It could have some stipulation. It could say bonds payable due in 3 months or something like that and that should trigger that we're talking about a current liability there, but without any other information, they're long-term. Cool? How about prepaid expenses? Well, prepaid expenses are generally current, right? This is maybe when we paid rent in advance or insurance in advance. This is a current asset, right? These are expenses that we've paid in advance, but we haven't gotten the benefit for them yet, so they're current assets. We could have long-term prepaid expenses, but they would have to tell us specifically about that. And finally, retained earnings, we know is an equity account, right? This is the equity, these are earnings that we've earned in the past and not paid out to the stockholders as dividends, so it still belongs in equity. Cool. So we've found all our current assets and current liabilities. Let's go ahead and add them up. Let's start with our current assets. So we had cash of 45,000, we had accounts receivable of 10,000, inventory of 25,000, and prepaid expenses of 15,000. Alright, so let's go ahead and add those up. I'm going to get a calculator. I don't want to think too much about this: 45 plus 10 plus 25 plus 15, that tells us that we've got 95,000 in current assets. Let's go ahead and do our current liabilities now. So what do we got? Short-term debt of 40,000. We've got accrued expenses of 35,000, and last is accounts payable of 30,000. So that's all of our current liabilities there. Let's get our number. 40 plus 35 plus 30. Well, that's 105,000 in current liabilities. Cool. So now, we've got our numbers. We've got our current assets. We've got our current liabilities. Let's go ahead and do our current ratio. And remember, that's current assets divided by current liabilities. So our numerator is 95,000 current assets divided by our denominator of current liabilities, 105,000. Right? And even without doing the ratio, you can already tell. Right? Those current liabilities are more than our current assets. So we're going to get something below 1. So let's see what we get. 95105. Well, that gives us a ratio of 0. I'll round it to 2 decimals. 90. Right? Current ratio of 0.90 and what was our threshold, right? We had a threshold for the current ratio at 1, right? So anything below 1, that's a red flag that we've got liquidity problems. And this makes sense. In the coming year, we're going to have to pay out a 105,000. But in the coming year, we're only going to have the equivalent of 95,000 in cash. So how are we going to cover all those? We might have to take on more debt, we might have to call more equity from our stockholders, we're going to need some more money to cover those. So our current ratio is 0.90. Let's go ahead and do working capital. We'll do it right underneath. Working capital, and remember that's just the subtraction of the 2, right? We're going to do the 95,000 in current assets minus the 105,000 in current liabilities and that gives us a negative 10,000, right? So we've got negative working capital and that gives us that same red flag, right? We might have a problem off our liabilities in the coming year. Cool? So that's how we're going to be analyzing these ratios in this class. Current ratio, working capital. These are pretty simple, right? We'll probably do some more complicated ratios as well, but let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the current ratio and how is it calculated?

The current ratio is a key liquidity measure that indicates a company's ability to cover its short-term liabilities with its short-term assets. It is calculated using the formula:

$\frac{\mathrm{Current Assets}}{\mathrm{Current Liabilities}}$

A current ratio above 1 suggests that the company has more current assets than current liabilities, indicating good liquidity. Conversely, a ratio below 1 signals potential liquidity issues, as the company may not have enough assets to cover its short-term obligations.

What does a current ratio below 1 indicate?

A current ratio below 1 indicates potential liquidity problems for a company. This means that the company has less than $1 of current assets for each $1 of current liabilities. In other words, the company may not have enough short-term assets to cover its short-term liabilities, which could lead to financial distress if it cannot meet its obligations as they come due.

How is working capital calculated and what does it signify?

Working capital is calculated by subtracting current liabilities from current assets:

$\mathrm{Working Capital}=\mathrm{Current Assets}-\mathrm{Current Liabilities}$

Positive working capital indicates that a company has sufficient short-term assets to cover its short-term liabilities, suggesting financial stability. Negative working capital, on the other hand, signals potential short-term financial problems, as the company may not have enough assets to meet its upcoming liabilities.

Why is it important to maintain a current ratio above 1?

Maintaining a current ratio above 1 is important because it indicates that a company has enough current assets to cover its current liabilities. This suggests good liquidity and financial health, as the company can meet its short-term obligations without needing to sell long-term assets or take on additional debt. A ratio below 1 could signal liquidity issues and potential financial distress.

What are the implications of having too much working capital?

While positive working capital is generally a good sign, having too much working capital can indicate inefficiency in asset management. Excessive working capital means that a company has more short-term assets than necessary, which could be better utilized elsewhere. For example, the company could invest in long-term assets, pay down debt, or return capital to shareholders. Efficient asset management is crucial for optimizing liquidity and overall financial performance.