If you know anything about business finance, you must have heard about working capital and that it is linked to short-term assets/liabilities. As soon as, you search for this on the internet you will find tons of rehashed resources. You will certainly get the list of line items on each side, but not the understanding of their profound effect on your business. What you must understand, as an entrepreneur or finance professional, is that not all current assets and current liabilities are made equal. Not only do they vary in characteristics, but also in liquidity. Does it matter? Yes.
Why Liquidity Matters
Current ratio is a high-level analysis implement that reflects the balance between short-term assets and liabilities. “Short-term” here implies 365 days, which corresponds to the annual operations. While this does provide some critical insights, short-term solvency is best tested against the operating cycle. This is the length of time the entity needs to complete one cycle of operations end-to-end.
For instance, if you’re a manufacturer you will start with acquiring some raw material, likely on credit. You will process it into your end product and sell it cash or credit. Through this process, you got a credit that remains your liability during this cycle. On the other hand, you had a stockpile of raw materials and some manufactured goods ready for sale. This inventory is your current asset. You also may have some cash in the bank. When you make your cash sales, you get money in your account instantly. In case of credit, though, you receive the money after some days. The cash and credit sales (Accounts Receivable) also form a part of assets. Therefore, your operating cycle started from the moment you took the credit and ended when your AR converted into cash.
This period varies from one business to other and solvency during this time is critical for the survival of an enterprise. Most types of operations will fall within the range of 15-90 days. And this is where the liquidity of each component starts to matter. Some of the simple yet powerful standard tools to facilitate this “health-check” are Quick Ratio and Super-Quick Ratio. Let us discuss the constituents item-by-item.
This usually refers to the total bank balance a business holds, including certain interest-bearing deposits that are realizable on demand. Even within this class, internet / mobile banking is faster than branch withdrawals (ATMs and Checks). Barring weekends, bank holidays and exceptional circumstances, cash represents the most definite, immediately liquefiable asset. Within an operating cycle, cash usually includes the amount realized from Accounts Receivable related to the previous period, the sale of other assets, and loans / equity funding.
Companies often park their excess cash in investment instruments – debt or equity. This class of current assets has highly variable liquidity that depends upon the choice of the portfolio. For example, investments in equity shares of blue-chip companies usually enjoy high trading volumes at the bourses. It is relatively easier to sell them anytime if the prevailing market price is promising. On the other hand, some types of government bonds may come with a locking period and have an almost non-existent secondary market.
Also known as “trade debtors”, this current asset is largely influenced by the industry in which a business operates. Though, there could be some deviations – circumstantial or strategic. A very new business or the one whose reputation has been flagging may have to offer more liberal credit terms to its customers. Sometimes, an entity may extend different credit terms to different categories of customers, such as bulk buyers.
Bad debts are a real threat to the convertibility of AR. The companies that have been into business for some time, use historical evidence to create provisioning for bad debts. New concerns must go by the industry average unless they have some additional information.
If you really want to test your inventory, you must classify it by the type and expiry date. For example, if you deal in perishable items you must estimate the losses on similar lines as AR above. Only the net value is what you should consider an asset. To bring about this level of accuracy either you should hire a very experienced Accounts & Finance team or seek help from an outside consultant.
Advances, Prepaid Expenses, and Refundable Deposits
This item is rather simple to understand. Any type of commercial merchandise or services for which you make advance payments or security deposits are included here. To assess their actual value, you should be able to answer questions, such as:
- Is the security deposit refundable?
- If I terminate a service contract midway, will I get the refund for the remaining term? How much?
- How long will it take to reflect that amount in my bank account?
Unless you terminate a service / purchase, prepaid expenses are completely illiquid and therefore, excluded from the stricter analytical tools, like Quick Ratio.
It goes without saying that you will need to analyze current liabilities the same way as current assets. However, the liabilities demonstrate much less variance in materialization than the assets.
This component relates to your credit purchases we discussed above. When they fall due depends upon the credit terms extended by your suppliers. Even if the credit terms vary by the type of inputs or vendors, they are likely to fall due within your operating cycle. Let us suppose you have an operating cycle of 60 days and your Accounts Payable constitute of three payment terms – 15 days, 30 days and 45 days. You will need to pay your entire AP within 45 days.
Your customers might make advance payments for your goods or services. This becomes your liability up to the time when you make the delivery.
This includes the current portion of long-term debt (falling due within the year) and short-term borrowings. In this context, bank overdrafts represent an interesting case. You can learn all about it in our blog post.
Income Tax Payable
While the final settlement of Income Tax falls due annually, advance tax installments fall due quarterly. In either case, this item will appear in the Balance Sheet as on the last day of the period. This is because the total tax can be estimated only after the period ends and the statutory payment falls due a couple of weeks after the period end.
Bringing Everything Together
For statutory or external reporting, the standard measures of current assets and working capital apply. An example would be a banking loan proposal. Though, this deep-dive is a vital input for management decision-making. If you are analyzing the filed financial statements of other companies, you will have limited data for a detailed analysis.
In case of your own financials, you will have the access to all the necessary data. The small businesses may argue that this entails a lot of tedious calculations or record-keeping. Here’s is the good news. Even if you have your numbers stored manually in spreadsheets or exported from your accounting software, you can extract the necessary information with functions, as simple as, a pivot table. You just need to know where to look. Working with experts certainly saves you a lot of time and money, in addition to better effectiveness. There is no reason why financial prudence and strategic approach should not be available to SMBs. Our solutions are designed with an eye on costs and utility. Contact us is really simple. Just pick up your phone and WhatsApp us at +919654421064.
Apart from the obvious benefit of an appraisal of the short-term solvency, Quick and Super-Quick ratios are the devices for better resource allocation. Remember, on the other side of resource crunch is the unprofitably locked-in resources. Before you rejoice about a higher than average current ratio, stop and check if your balance sheet has idle assets. More often than not, this is what it indicates. This detailed analysis also allows you to test the health of each category and identify any cashflow imbalances. In the short run, it is the cashflows that keep a business afloat.
It may so happen that your operating cycle is more or less than 90 days. Can you reconfigure the parameters to match your desired period? Absolutely. This is the beauty of this technique. You only need to map the individual elements to your chosen time period. In addition to SMS/WhatsApp, you can write to us at firstname.lastname@example.org. You can also follow us on Facebook.
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