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Financial Accounting

Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

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14. Financial Statement Analysis

Ratios: Working Capital and the Current Ratio


Ratios: Working Capital and the Current Ratio

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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. We talk about liquidity. Remember the liquidity of assets is how easily they can be converted to cash. And we're gonna be talking about our current assets and current liabilities here. So this is basically dealing with being able recover 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, that is all of our assets that are cash or converted into cash within one year? And current liabilities? Well, that's money we're gonna have to pay out within one 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 currently Liabilities or less than $1? Current assets per for dollar of current liabilities, what 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. What 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, This is a big red flag here. This is usually when you're doing an analysis or if you're doing a project where you're looking at a company, this is a great way to tell if this current ratio is in good condition. So, current ratio below one point. Oh, right. Below one. 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, it's not technically a ratio. Right? It's not technically a ratio because we're not dividing one number by another. Alright, sorry about that. Um but it's still a useful financial analysis tool that 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 are 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, what we're going to see is when we have negative working capital, just like when we have a current ratio under one, right, A red flag here is if we see negative working capital, well, that's gonna 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 fix 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. Right. Also, another thing to think about is if you have some huge amount of working capital, a really high amount of working capital, it could mean you're in efficiently managing your assets, right? You have just way 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 know whenever you're doing ratio problems, you're generally they're usually pretty simple. Especially when they come up on a test. These are like three points. All you have to do is remember the ratio. And it's it's as simple as just dividing two numbers or something like that on the 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 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. Low. The 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 could expect. Sometimes you get questions that are this easy. How bad would it be to lose points on something like this. Let's go ahead and start with our current ratio, the current ratio. Well, remember, we have our current assets will 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 300? Well, that's a bad line divided by 315,000. Not much better there. Well, what's that? Give us 4 50 divided by 3 15. Right. And you can just do 4 50 divided by 3 15. Right. It's gonna give you the same answer. Take off those zeros. So we get a current ratio of 1.43. I'll round it off to two 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 one. So this is a good sign that this company is in decent position to cover their 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 gonna be our current assets of 450,000 minus current liabilities of 315,000. Right. And we just do that for 50 minus 3 15. And it gives us 100 35,000 As working capital. So that means we have a dollar amount. Right? This is a dollar amount right here 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.

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