12. RATIO ANALYSIS
Concept of working capital has its own importance in a going concern in the smooth running of a business. It is useful both for the financial management and for the executives of an undertaking. Usually, the working capital balance of a going concern has a positive value but often the uses of working capital exceed the sources of working capital. In efficiently, managed companies, such deficits are soon offset by gain in the following periods. A study of the causes of changes in the uses and sources of working capital is necessary to observe whether working capital is serving the purpose for which it has been created or not. This involves the basic approach to working capital analysis.
The analysis of working capital can be made either through
1) Ratio Analysis:
The ratio analysis of working capital helps the management in checking upon the efficiency for which the working capital is being used in the business.
The ratio analysis takes two forms-
1. To analyze the behavior or ratios over a period of years in the business, and
2. To compare ratios for one concern with those of other concerns in the same line of business.
The important ratios are:
A. Turnover to Working Capital Ratio:
It is a relation between net turnovers to net working capital. The ratio shows how many times the working capital turns over in trading transactions. Higher ratio shows efficient use of working capital.
Net Sales
Turnover of Working Capital Ratio = ------------------------------
Net Working Capital
B. Current Ratio:
It is the ratio between the current asset and current liabilities. It measures the ability for the company to pay its short-term debts.
Current Assets
Current Ratio = ---------------------------
Current Liabilities
C. Acid Test Ratio:
It is the ratio between the quick asset and current liabilities. It promises strong financial position.
D. Cash Ratio:
It is the ratio between current asset and cash. It promises availability of cash to meet day-to-day requirements. Higher ratio shows idleness of fund.
E. Ratio of Current Liabilities to Tangible Assets:
The ratio is the relation between the current liabilities to the total net worth of the company. This shows a comparison between funds contributed by the short-term creditors and those contributed by owners.
2) Fund Flows Analysis:
It shows the sources of the fund and their application in business. By this method changes in current assets and current liabilities are noted very carefully so that corrective actions may be taken immediately.
3) Budgeting Analysis:
The analysis is made by preparing working capital budget to compare the budgeted figures with those of actual performance.
