METHODS OF WORKING CAPITAL ANALYSIS
Working capital management involves the management of different components of working capital, such as cash, inventories, accounts receivable, accounts payable, etc. In order to assess whether the available working capital is serving the purpose for which it has been raised, working capital analysis becomes inevitable.
The analysis of working capital can be made by employing
the following three tools or techniques:
Funds Flow Analysis:
Fund flow analysis is a useful tool for working capital analysis
and is widely used in financial analysis. Fund flow analysis is the study
of the sources of funds and their application in the business. It shows the
sources and uses of funds. By the use of this technique, changes in the working
capital between the two dates can be easily analyzed by studying the changes in
each type of current assets and current liabilities. Fund flow analysis as an
instrument of analysis of working capital answers a number of intricate
queries, such as--the overall creditworthiness
of the concern, sources of repayment of the loan taken, the quantum of funds
generated during a specific period, etc.
Ratio Analysis:
Another tool of working capital analysis is
the technique of ratio analysis, which is widely used by the corporate sector
for checking working capital is upon the efficiency with which it the being
utilized in the business. It serves as a useful tool for financial analysis. The important
ratios for determining the trend in business over a period of years are as
follows:
Current Ratio = Current Assets/ Current Liabilities
where,
Current Assets- Those assets which are easily converted into cash within one year. For eg. Debtor, Investment, Bill receivables, etc.
Current Liabilities- Those liabilities which are payable within one year. For eg, Creditors, Bills payable, Bank overdrafts,s, etc.
The current ratio is an index of the company's financial stability as it shows the extent of the working capital. A higher current ratio indicates inadequate employment of funds while a lower current ratio is a danger signal to the management. It shows that the company is trading beyond its resources. The ratio of 2:1 is considered an ideal current ratio. A very high ratio is undesirable since it means less efficient use of funds.
Liquidity or Acid Test Ratio: This ratio is also termed as
'Quick Ratio'. It is determined by dividing liquid assets, i.e., assets that
are immediately convertible into cash,
by current liabilities. Prepaid expenses and stock are not taken as liquid
assets. The ratio may be determined as follows:
Liquidity Ratio = Liquid
Assets/Current Liabilities
where,
Liquid Assets- Those assets which are easily converted into cash within one year. For eg. Debtor, Investment, Bill receivables, etc.
Current Liabilities- Those liabilities which are payable within one year. For eg, Creditors, Bills payable, Bank overdrafts,s, etc.
This ratio is also an indicator of the short-term solvency of
the company. It serves as a better test, of the financial strength of a concern than
the current ratio because it does not take into consideration such inventory
which cannot be sold at fair prices immediately. The liquidity
ratio of 1: 1 is considered ideal. A higher liquidity ratio indicates a better
financial position, whereas a lower liquidity ratio indicates over-stocking by
the concern and tight Working capital situation.
Budgetary Analysis:
A careful estimation of working capital
requirements is a precondition for efficient working capital management. In
this regard, a working capital budget as a part of the total budgetary process is
prepared. The basic objective of the working capital budget is to use the funds
efficiently. At the end of the budget period, figures and the actual comparison between the budgeted figures
can be made and studied using different ratios, standards, and charts.
It is clear from the above discussion that effective working
capital analysis is necessary for efficient working capital management. The
flow analysis and management may use the ratio analysis, and finds budgetary
analysis techniques of working capital analysis. A close watch on different
ratios and the funds flow position would enable a company to take the necessary
corrective actions efficiently and immediately.
