Erroneous Views about a Company’s Existing Position
Business working capital is nothing but the difference between these categories of assets and liabilities, shown as an absolute figure.
Despite conventional wisdom, a company’s existing position has little to no relevance to a measurement of its liquidity. Even so, this standalone figure is prominently reported by investment research services and in financial communications like the annual report. Whatever the size, a company’s working capital does not say much about the quality of its liquidity position.
Another generally accepted belief which needs rectifying is the one concerning the interpretation of the working capital ratio and acid test ratio, which are basically two analytical tools. Contrary to popular view, these do not convey evaluative details about an organization’s liquidity which an investor has to know. The former ratio is a sign of liquidity and is very flawed because conceptually it is based upon the liquidation of current assets of a company to settle its current liabilities in their entirety. In actuality, this is unlikely to happen. Investors need to consider a company a going concern. It is the time taken by a company to convert its current assets into cash, for paying off its short-term obligations, which plays a key role in its liquidity. The working capital ratio is very misleading compared to these things.