Financial Analysis: Defining Liquidity and Working Capital Management
I. Objectives:
  • Know the relevance and importance of effectively managing working capital.

  • Define liquidity and its relationship with working capital.

  • Know short-term and long-term asset management ratios to control working capital and the firm's liquidity.

II. Working Capital Management

Working capital management examines the relationship between short-term assets and short-term liabilities. The process oversees control of the firm's cash, inventories, and accounts receivable/payable. The intent of participating in working capital management is to ensure:

  • operations continue
  • available business cash exceeds current liabilities
  • the firm can satisfy maturing short-term debt, as well as future, operational expenses

A working capital deficit in the short term impacts operations, as well as the firm's profitability. Long-term inefficiencies compromise the firm's credit worthiness, which impacts its ability to get low-interest loans and, consequently, to attract potential investors.

Ratio analysis aids in identifying areas of weak or poor performance in management of the firm's cash, inventory, and accounts receivable/payable.

A. Liquidity

The firm's ability to pay short-term debt and expenses (aka current liabilities) within the one-year operating cycle is its liquidity. Balance Sheet asset accounts are listed in order of liquidity. The first category of current assets addresses items that can be converted into cash within the normal one-year operating cycle. Total assets are funded through liabilities or stockholders' equity. Current liabilities, which must be paid within one year, are paid out of current assets.

Noteworthy current assets, in addition to cash, include:

  • Marketable Securities - temporary investments of excess cash
  • Accounts Receivable - which include an allowance for bad debts to determine their collection value
  • Inventory - raw materials, goods in process, or finished goods
  • Prepaid Expenses - future expenses that have already been paid (i.e.: insurance premium, rent)
  • Investments - a longer term funds commitment (i.e.: stocks, bonds), and
  • Plant and Equipment less Accumulated Depreciation - the original cost and all accumulated past and present depreciation charges on owned assets (not the same as the Income Statement depreciation expense)

Liabilities revert from current liabilities to long-term debt, if not satisfied within one year. Short-term liability obligations include:

  • Accounts Payable – amounts owed on supplier accounts
  • Short-Term Debt – signed obligations owed to creditors, and
  • Accrued Expense – service provided that has not yet been paid

A firm's liquidity is calculated using current assets and current liabilities.

  • LOW LIQUIDITY indicates poor management or financial problems.


  • TOO HIGH A LIQUIDITY RATIO indicates excess funds, which incur an opportunity cost that could be invested to gain a higher return.

The firm's liquidity may be calculated using the:

  • Working Capital Ratio

  • Current ratio, and

  • (Quick) Acid-Test Ratio

B. Working Capital

The excess of current assets over current liabilities is the firm's Working Capital. Working capital is required for daily routines and operations, such as paying salaries, suppliers, creditors, etc. Working Capital is a measure of the firm's liquidity. It is calculated using the assets and liabilities listed on the Balance Sheet.

A significant amount of working capital indicates healthy levels of liquidity. Assets that increase over time are a good indication of the firm's growth. Effective current asset planning is the ability to accurately forecast sales, and match production schedules with the sales forecast. When actual sales and forecast sales are different, inventory reductions or build-ups likely occur, which affect receivables and cash flow.

Typically, a firm's fixed assets slowly increase as its capacity for production grows and equipment is upgraded. Current assets which are dependent on production and sales levels, however, fluctuate in the short-term. Inventory increases as the firm produces more than it sells. When sales outpace production, inventory decreases and receivables rise.


WORKING CAPITAL = Current Assets - Current Liabilities
  • Positive working capital is a fair indication the firm has the financial ability to pay off its short-term debt.

  • Minimal or negative levels of working capital proportionately indicate low levels of financial capacity and profitability.
  • When the working capital balance is very large, there is still no assurance debts will be paid. Rather, it can easily indicate stagnant inventory, or an excess inventory of a product that is not moving.

Supplemental ratios should be used to gain details about the character of the working capital, as well as to ensure assets and liabilities computations accurately reflect the true makeup of the firm's working capital, and liquidity.

Investors, creditors, and corporate others are concerned with the firm's working capital, since it is indicative of the firm's financial health and efficient operations. If the firm's inventory, accounts receivable, accounts payable, and cash accounts are being managed effectively, it will be reflected in its working capital.

Mathematically, if the working capital ratio is less than 1, it indicates the amount of liabilities exceeds the amount of assets. The result is negative working capital and the firm could soon experience financial difficulties, or bankruptcy.

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A high working capital ratio can indicate an excess of inventory, or that surplus assets are not being invested into the company. The preferred working capital ratio varies according to industry. However, a working capital ratio between 1.2 and 2.0 is generally considered acceptable.

Regardless if the business is a startup or it has been in operation for awhile, running smoothly, and growing, the working capital is a practical thermometer to determine the firm's overall financial health. The calculated amount of working capital denotes the firm's liquidity and profitability, and should be considered an important decision-making tool.

C. Short-Term Creditors


Receivables are assets that consume working capital, such as loans, including unsettled transactions and debts, extended to customers. Receivables include all debts owed to the firm, regardless if they are currently due or not. Short-term receivables are included in the firm's current assets on its Balance Sheet. Long-term receivables which will not come due for some time, are recorded as long-term assets.


The Current Ratio is the "liquidity ratio." It is a measure of the firm's ability to pay its short-term debt. It calculates the assets that must be converted to cash during the year period in order to sufficiently pay the current debt that is owed. The general Current Ratio rule is to have a current ratio of 2:1, although this varies within some industries that may successfully operate with a ratio slightly above 1:1. Asset composition determines the ratio's adequacy.

Other influencing factors, such as the handling of inventory, having problems getting paid on their receivables, or reinvesting excess can impact overall liquidity and success of the firm. Regardless, it is agreed that a ratio less than 1 indicates the company will have difficulty paying its short-term debt and payables. This is not, however, necessarily a true indication that the company will go bankrupt, either.

Current Assets

CURRENT RATIO = Current Liabilities

Interpretation should be done carefully. As previously stated, a ratio that is too high, (3 or 3.2 for example), may indicate the company is not properly reinvesting (to encourage future growth), has an excess of inventory, or on the other hand, has an improving financial situation. Too much cash on hand is as unhealthy as not enough.

Similarly, when ratios of several companies are compared, it must be understood that there are other circumstances impacting stability, and a preferred minimal 2:1 ratio may not be a true and sufficient working capital bottom line reality.


The Acid-Test Ratio is a more robust method of measuring a firm's ability to meet its short-term debt and obligations. The formula uses more liquid ("quick") assets. Prepaid expenses and merchandise inventory are excluded from the total of current assets.

Cash + Marketable Securities + Current Receivables

(QUICK) ACID-TEST RATIO = Current Liabilities

The basic intent of the Acid-Test Ratio is to measure how well a firm can pay its debt and obligations without needing to liquidate its inventory. Inventory is not an immediate source of cash, so it is logical to exclude it as a readily available source. It also runs the risk of not being salable at all during economic downturns.

A 1:1 Acid-Test Ratio is generally acceptable based on the commonly held idea is that every dollar of liabilities should be balanced or backed by a comparable dollar of quick assets.

This ratio must be interpreted in respect to its components. Upon analysis, evidence that a cash position deteriorates while short-term debt is increasing may be indicative of a growing number of accounts receivable.


The Accounts Receivable Turnover, or Collection, Ratio measures how many times during the year period the company has converted its accounts receivables into cash. It is associated with working capital analysis because the ratio generally indicates the smooth transition from accounts receivable into cash, which is an important indicator of a firm's ability to operate and the quality of its working capital.

A high ratio may indicate the firm is having difficulties getting paid for its service or products. Industries or products that are seasonal may experience ratio increases and decreases according to peak and off seasons. To get a more accurate ratio, the average of the beginning accounts receivable and ending accounts receivable may be used.

The Accounts Receivable Turnover Ratio is referred to as the Collection Ratio, because it considers the average number of days, or amount of time, the receivable were outstanding – the collection period.

The calculated turnover ratio divided by 365 days (referring to the average daily sales) results in the collection period.

The average days it takes to collect an account may be good or bad, depending on the terms of the credit agreement. For example, if the average collection period is 35 days and the terms of the credit are 30 days, then the average collection period may be viewed as "good." On the other hand, a firm with credit terms of 15 days should be concerned. They may have too many old accounts, poor daily management of credit, or inadequate credit checks.


The Inventory Turnover Ratio effectively assesses the efficiency and effectiveness of working capital management. It is an indicator of how quickly inventory is turned over, and gotten off their shelves, or how many times during the year period the inventory has been sold.

In general, a high inventory turnover ratio is good, since no cash is gained from products sitting on the shelf. Consideration must also be given, however, to inventory increases (stockpiling) in anticipation of sales. Investors compare a firm's Inventory Turnover Ratio with other similar firms within the industry, before determining what is normal, and what is above-average operation.

Similar to Accounts Receivable Turnover, an Inventory Turnover rate, or the average sale period, may be determined by dividing 365 by the inventory turnover figure. Again, excessively high stocks of inventory may give indication of obsolete goods sitting on shelves that should be liquidated. On the other hand, inventories that move faster than the observed industry average may indicate a lack of inventory on hand and that maintained inventory levels are inadequate.


The Days Sales Outstanding (DSO) is also called the average collection period. It is used to appraise accounts receivable. The DSO is the average time the firm must wait after making a sale before receiving cash. The average daily sales is divided into accounts receivable to determine the number of days sales were tied up in receivables.

The DSO should be compared with the terms on which the firm sells its product. For example, if the collection period trend (over years) has been rising and the credit policy has not changed, accounts collection should be expedited. Otherwise, the firm runs the risk of not having sufficient cash to fund short-term obligations.


The Cash Conversion Cycle, or cash cycle, is a measure of working capital efficiency relative to the firm's short-term financial plan. The Cash Conversion Cycle measures the average number of days working capital is tied up in operations.

The Cycle:

1. Starts with ordering materials for inventory (DIO) production on credit (no immediate cash flow);

2. Wages will accrue (not fully-paid at the time work is performed);

3. The finished product is sold on credit (receivables created (DSO) – no immediate cash flow);

4. The company pays for materials and wages (accounts payable (DPO) – net cash outflow -- must be financed, since it is paid before receiving any cash profit from sales);

5. The cycle is completed when receivables have been collected, the company can pay off its credit used to finance production, and optimistically, a profit is realized.

D. Long-Term Creditors

Long-term creditors are concerned with both short-term and long-term financial positions and the firm's ability to meet all financial commitments. Interest is paid on a current (short-term) basis and (long-term) holdings are eventually retired. Various restrictions are imposed on riskier long-term debt, because creditors prefer the safety of interest and eventual repayment of principal on consistent cash flows, rather than go to the possibility of having to collect on claims.


The Times Interest Earned Ratio, also referred to as the interest coverage ratio, may be considered a solvency ratio, because it measures the ability of the firm's operations to pay the long-term creditor.

Operating income, or, the income before interest and taxes (EBIT), and the interest expense figures are found on the Income Statement. The Times Interest Earned Ratio is expressed numerically, rather than as a percentage.

Larger ratios indicate the better likelihood a firm can pay the interest with its before-tax income. For example, a ratio of 3 indicates the firm has the capacity to pay its accrued interest expense the equivalent of three times during a year period. Creditors prefer seeing a higher Times Interest Ratio of 2 or more. It indicates the firm has the ability to pay its interest payments when they are due. Lower ratios broadcast a credit risk. However, no decision should be made until a long-term trend has been thoroughly examined.


The Debt-Equity Ratio determines what portion of assets is provided by the creditors and what portion of assets is provided by the stockholders. Essentially it illustrates the amount of debt the firm has in its capital structure.

Large debts mean the borrower must pay significant principal and interest. This ties up cash and increases the risk of finding that resources are depleted in the event of an emergency.