Optimum Working Capital
- If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money quickly.
- Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it) has traditionally been considered the best indicator of the working capital situation.
- It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital. This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one). Thus it is considered that there is a comfortable liquidity position if liquid current assets are equal to current liabilities.
- Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have, for years, considered the current ratio at ‘two’ and the acid test ratio at ‘one’ as indicators of a good working capital situation. As a thumb rule, this may be quite adequate.
- However, it should be remembered that optimum working capital can be determined only with reference to the particular circumstances of a specific situation. Thus, in a company where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound.
- In nutshell, a firm should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous.
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