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Current liabilities, working capital and related ratios - Views on News from Equitymaster
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  • Sep 15, 2009

    Current liabilities, working capital and related ratios

    In the previous article of this series, we discussed one of the components of the 'Application of funds' side of the balance sheet - current assets. In this article we shall take a look at another component - current liabilities and will also discuss about working capital.

    As compared to long term liabilities (debt), current liabilities are obligations that are due within a period of one year. The concept of current liabilities is similar to that of current assets. As companies buy goods and services on credit from their vendors and suppliers, the latter becomes their creditors. As such 'sundry creditors' are bills that are due to creditors and suppliers within a short period of time. It also includes provisions made for a particular year. It usually includes payment of dividends, interest and taxes. Other current liabilities include loans and advances from customers as well. These are basically payments that a company receives in advance. The higher the amount of loans and advances, the better it is for a company as it is able to fund its operations without being charged any interest on the funds.

    Moving on, to know the average number of days at which a company meets its short term liabilities, one calculates the creditor days. The formula for the same is similar to that of debtor days.

    Creditor days = Sundry creditors/sales * 365

    Let us take up an example to understand this well. As of 31st December 2008, the sundry creditors on Nestle's books were Rs 5 bn. During CY08 the company recorded sales of Rs 43 bn. As such on using the above-mentioned formula, the result is 42 days. This means that the company takes nearly 42 days to pay off its creditors.

    In the previous article of this series, we calculated Nestle's average debtor days as 3.8 days. This means that the company is able to collect its payments within an average period of 3.8 days. But on the other hand it takes nearly 42 days to pay off its creditors. This indirectly indicates that the company has a very strong bargaining power, both against its vendors and debtors.

    To assess how comfortable a company is in terms of meeting its short term liabilities, we can use ratios such as the current ratio and the quick ratio. Current ratio is calculated by dividing current assets by liabilities. As such:

    Current ratio = Current Assets / Current Liabilities

    Quick ratio on the other hand is calculated by dividing current assets minus inventories by current liabilities. Therefore:

    Quick ratio = (Current Assets Inventories)/ Current Liabilities

    These ratios indicate the short-term liquidity of the company. The higher the ratio, stronger is the short term liquidity position of the company. If the ratio is 1 or higher, it means that the company has enough cash and liquid assets to cover its short-term debt obligations. If a company's creditors exceed the debtors it is possible that it could run into trouble paying back creditors in the short term. However, it may be noted that it is not always necessary that a company having a ratio of less than 1 (or indirectly current liabilities are more than current assets) is not in a strong position.

    At the end of FY09, the current liabilities on Hero Honda's books stood at Rs 15.5 bn, while its current assets totaled to Rs 10.1 bn. The current ratio in this case is 0.65. This is one strong advantage for the company as it is able to generate cash so quickly. This is the case as its customers (two-wheeler owners) usually pay upfront. Indirectly, as the company has higher creditor days, it means that it is actually receiving cash for products even before it is making payments to its creditors.

    Working capital
    Working capital is calculated by subtracting current assets by current liabilities. As indicated above, the rule of thumb is that positive working capital means that a company is able to pay off its short-term liabilities.

    What is the average amount of working capital needed by a company is calculated by dividing the net working capital figure by net sales of a particular year. It may be noted that this is an average figure and as such only gives an indication.

    'Working capital turnover' is a ratio that helps in knowing how many days it takes a company to convert its working capital into revenue. The faster a company is able to do so, the better it is. The formula for the same is:

    Working capital turnover = (Average Working Capital/ Net sales) * 365

    When utilizing this ratio, it is important for one to see the long term pattern of the company. More important is how it fares when compared to its peer group.

    In the next article, we shall discuss about investments and the different types of investments found in companies' balance sheets.

    Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article



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