Working capital is defined as the amount of current assets minus the amount of current liabilities. To illustrate, assume that ABC Corp has current assets of $2,000,000 and current liabilities of $1,600,000. ABC's working capital is $400,000 and its current ratio is 1.25 or 1.25 to 1 ($2,000,000 / $1,600,000).
If ABC's current assets include inventory and prepaid expenses of $600,000, its quick ratio (or acid test ratio) is 0.88 ($1,400,000 / $1,600,000).
Liquidity refers to a company's ability to pay its current liabilities when they come due. Some current liabilities (short-term bank loans, accounts payable, wages payable) may be coming due within weeks. If the company cannot sell its inventory and collect its receivables for several months, it may not have the necessary liquidity to pay these liabilities (even if it has a positive amount of working capital).
Therefore, other financial ratios involving current assets are also important. These ratios include inventory turnover, days sales in inventory, receivables turnover, and average collection period. However, you must realize that these ratios are typically calculated using amounts from the previous year.
The company's debt to equity ratio is an important indicator of a company's ability to obtain additional long-term financing that will improve its working capital and liquidity.
It is also possible that a company selling high-demand products online and receiving cash from the credit card processors within days (and is allowed to pay its suppliers 30 days after receiving the products), may require little or no working capital.
Some companies sell their receivables to companies known as factors to improve their liquidity. Others offer their credit customers early payment discounts if the customers pay in 10 days instead of 30+ days.
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Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. Read more about the author.