Liquidity ratios are a group of ratios used to measure the ability of a business operation to meets its current obligations. Liquidity ratios are similar to the initial medical tests a patient receives at a doctor’s visit. Doctors take blood pressure, temperature, and pulse rate. The doctor wants assurance that the primary indicators of health are good. Liquidity ratios are exactly the same. The user wants to know that the basic measurements of a business indicate good health today.
Working Capital Cycle
The working capital cycle broadens the definition of working capital to include the contribution to working capital based on the production/sale and collection cycle; i.e. increasing working capital via the contribution margin of the product life cycle.
The use of the working capital cycle requires a sophisticated understanding of the entire economic cycle involved with purchasing inventory, selling the product and collecting the respective cash.
The activity ratios measure performance of a current asset on the balance sheet against a corresponding area of the income statement. The working capital turnover is the most encompassing of all the activity ratios; in effect, it is the most general of the activity ratios. This particular ratio measures the ability of management to efficiently utilize net current assets.
There is no single management style to address the multitude of working capital cycles existing in the various business sectors and the underlying industries. Taking raw resources and turning them into consumer goods has different time frames depending on the item produced. In addition, the sales period varies from product to product. Compare the production and sales cycle for an automobile to that of ice cream.
In business the best source of new business is the existing customer. Discovering the customer’s habits and characteristics allows the sales department to expand into new geographical territories with similar customer characteristics and/or modify the existing product lines. The key to success is gathering the proper information at the point of sale.