Did you receive it from a friend? Subscribe here for free.
Hello [FIRST NAME GOES HERE]
How are you doing?
You learnt and practice about the concept of working capital and the difference between net and gross working capital.
Now it’s time to learn how to analyze Working capital.
This week’s “Accounting Guide” is about the analysis of working capital
What is working capital analysis?
Working capital analysis is the process of calculating and interpreting the working capital ratio. The ratio is calculated by dividing the current assets with current liabilities. I know, I know you have question. I got it.
Why do companies analyze working capital?
Because working capital explores the current liquidity position of a company. As I told you earlier, current liquidity position shows ability of a company to meet its day-to-day operating expenses.
The main reason for analyzing working capital is to know how much working capital the company have and how much it requires to meet its day-to-day operating needs. Companies smartly manage their working capital by analyzing it.
It also shows the risk associated with the company. If the company has high levels of debts to pay in the current year rather than its assets and it also has shortage of funds. That means it is riskier to invest in it. It may not be able to meet its current obligations.
How to analyze working capital?
You need to find out the working capital of a company for analyzing its working capital. We can calculate the working capital by subtracting the current liabilities from current assets. The result could be positive, neutral or negative.
Positive working capital means the company has excess cash to invest after meeting its day-to-day obligations. Neutral working capital means it has enough cash to meet its obligations while negative working capital means it has shortage of working capital for meeting its day-to-day obligations, it needs funds to meet its day-to-day operating expenses.
Working capital of a company is further analyze by calculating and interpreting the working capital ratio.
Let’s get into it.
How to calculate working capital ratio?
Current assets include all liquid assets of the company whether they are tangible intangible.
Current Liabilities include short-term obligations of a company.
The higher ratio is the desirable situation, it means the company has funds and can meet its day-to-day operating activities and it is also able to invest in other activities.
While the low ratio is not an ideal situation, it depicts that the company have less funds or resources to meet its day-to-day obligations. It needs more cash to meet its day-to-day obligations. Companies needs to manage their working capital efficiently and effectively.
Let's analyze the working capital of Thomas incorporation. following are the year end balances of the company.
Thomas Inc. has $1,256,000 current assets and its current liabilities are $785,000.
The ratio calculation shows 1.6 ratio. It's a positive balance and it shows that the company have excess cash after meeting its working capital needs. it is a good sign of showing good financial health of the company.
- The ratio greater than 1 means a company is able to meet its day-to-day operating requirements.
- The ratio less than 1 means the company is not able to meet its day-to-day obligations.
Steps to analyze working capital
1. Identify current assets
2. Identify current liabilities
3. Divide Current assets by current liabilities
4. Interpret the ratio
Did you find value in this newsletter?
If yes, forward it to your friends, classmates, and peers because sharing is caring!
What should I add more in this newsletter? Do give your suggestions.
What do you want to learn more? Or what should I add in it. This newsletter is in its construction phase. Just reply to this email and suggest me.
I read every email. I will answer you sooner or later.
Credit for now
Hira from Accounting Drive
P.S: Add me to your contact list to ensure getting these accounting guides right in your inbox. Never miss these accounting guide!