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5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity

Understanding Liquidity​

Liquidity refers to a business's ability to meet its short-term obligations (debts due within one year) using its current assets.

Why it matters:

  • Indicates financial health
  • Shows ability to pay bills
  • Important to creditors and investors
  • Helps with cash flow management

Current Ratio​

The current ratio measures a business's ability to pay its short-term obligations.

Formula: Current Ratio = Current Assets ÷ Current Liabilities

Interpretation:

  • > 1.0: Business has more current assets than current liabilities (good)
  • = 1.0: Current assets equal current liabilities (adequate)
  • < 1.0: Business has fewer current assets than current liabilities (potential problem)

Generally:

  • > 1.5: Good liquidity
  • 1.0 - 1.5: Acceptable liquidity
  • < 1.0: Poor liquidity (may struggle to pay bills)

Calculating Current Ratio​

From Adjusted Trial Balance:

Current Assets:

  • Cash (510000): €15,000
  • Accounts Receivable (410000): €3,000
  • Inventory (321000): €4,000
  • Prepaid Insurance (460000): €1,100
  • Total Current Assets: €23,100

Current Liabilities:

  • Accounts Payable (400000): €8,000
  • VAT Payable (430000): €500
  • Salaries Payable (440000): €1,500
  • Interest Payable (450000): €100
  • Unearned Revenue (470000): €2,000
  • Total Current Liabilities: €12,100

Current Ratio Calculation:

Current Ratio = Current Assets ÷ Current Liabilities
Current Ratio = €23,100 ÷ €12,100
Current Ratio = 1.91

Interpretation: The business has €1.91 in current assets for every €1.00 in current liabilities. This indicates good liquidity.

Working Capital​

Working capital is the difference between current assets and current liabilities. It represents the amount of current assets available after paying current liabilities.

Formula: Working Capital = Current Assets - Current Liabilities

Interpretation:

  • Positive: Business has excess current assets (good)
  • Zero: Current assets equal current liabilities (adequate)
  • Negative: Business has insufficient current assets (problem)

Generally:

  • Positive and increasing: Improving liquidity
  • Positive but decreasing: Declining liquidity
  • Negative: Liquidity crisis (cannot pay bills)

Calculating Working Capital​

From Adjusted Trial Balance:

Working Capital Calculation:

Working Capital = Current Assets - Current Liabilities
Working Capital = €23,100 - €12,100
Working Capital = €11,000

Interpretation: The business has €11,000 in working capital, meaning it has €11,000 more in current assets than current liabilities. This is a positive sign.

What These Measures Tell Us​

Current Ratio Analysis​

Current Ratio = 1.91

What it means:

  • Business can cover current liabilities 1.91 times
  • Good liquidity position
  • Creditors would view this favorably
  • Business has cushion for unexpected expenses

Industry Context:

  • Restaurants typically need current ratio > 1.5
  • Retail businesses often need > 1.2
  • Service businesses may be comfortable with > 1.0

Working Capital Analysis​

Working Capital = €11,000

What it means:

  • Business has €11,000 available after paying current liabilities
  • Positive working capital indicates financial stability
  • Can handle short-term cash flow fluctuations
  • Provides buffer for operations

Limitations of These Measures​

Current Ratio Limitations:

  • Doesn't consider quality of current assets (e.g., slow-moving inventory)
  • Doesn't show timing of cash flows
  • Can be manipulated (e.g., delaying payments)
  • Doesn't account for seasonality

Working Capital Limitations:

  • Absolute number, not a ratio (harder to compare)
  • Doesn't show efficiency of asset use
  • Can be positive but still have cash flow problems
  • Doesn't consider future obligations

Improving Liquidity​

Ways to Improve Current Ratio:

  1. Increase current assets (collect receivables, sell inventory)
  2. Decrease current liabilities (pay down debt)
  3. Convert noncurrent assets to current assets
  4. Improve cash management

Ways to Improve Working Capital:

  1. Increase cash reserves
  2. Collect accounts receivable faster
  3. Manage inventory levels
  4. Negotiate better payment terms with suppliers
  5. Reduce unnecessary expenses

Luxembourg Context​

For Luxembourg SMEs:

  • Current ratio > 1.5 is generally healthy
  • Working capital should be positive
  • Important for loan applications
  • Creditors (banks, suppliers) monitor these ratios
  • Required for some government programs

Luxembourg Compliance Note​

While current ratio and working capital are not required by PCN, they are:

  • Important for financial analysis
  • Used by creditors and investors
  • Helpful for business management
  • Often included in management reports
  • May be required for loan applications

Think It Through​

A business has current assets of €50,000 and current liabilities of €60,000. What is the current ratio and working capital? What does this indicate about the business's liquidity?