The majority of activity ratios measure the ability of the company to turn assets into earnings. All businesses utilize a simple principle, buy an asset at a low price and sell it at a higher price. Even service based businesses do this. Labor is purchased for a certain value and then sold for a much higher price. Retail businesses purchase inventory and then turn around, mark it up and then sell it to make a profit. There isn’t any business out there that doesn’t exercise this basic business principle.
Working capital has several different interpretations but the core fundamental is all current assets less current liabilities. To understand and use this term properly, the reader must understand more than just the working capital definition, the reader must know about working capital cycles, proper management and its importance related to operating a small business.
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 small business, cash is almost always the number one issue. There is simply never enough. This is primarily attributable to growth. Growth requires both physical assets to produce more and expansion of accounts receivable. Technically, the expansion of accounts receivable is the economic equivalent of lending cash.
The current ratio is an inappropriate relationship to use or rely on in small business. The ratio is best suited for large publicly traded organizations. This article explains the basic formula for the current ratio, how to identify the ratio in reading financial statements, its purpose and the many drawbacks for its use with small business.
Cash disbursements is the process of remitting payment to vendors, suppliers and third party contractual obligations. Better managed offices pay bills in regular cycles including weekly and monthly obligations. Preparation, reconciliation and actual check writing is commonly referred to as cash disbursements.
The college textbook definition of working capital is current assets minus payables and accrued expenses. The term explains the dollar value of flexibility a business operation has to take advantage of immediate opportunities or endure sudden or long-term setbacks. Since it is a balance sheet based formula the value is a function of a moment in time.
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.