Working Capital

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    Oscar
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    1. Are liquid asset and current asset the same?
    2. In the current ratio which is Current Assets/Current Liabilities determines the liquidity (ability to settle current liabilities when they are due). The ideal ratio is 2:1 but why? Why do you need that much of current assets since 1:1 is enough to settle the current liabilities. Please explain this :(


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    John Moffat
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    1. No! Liquid assets are those that are immediately convertible into cash (cash itself, and short term investments). Current assets also include receivables and inventory which will take longer to convert into cash (it takes time to sell inventory, and then it takes time to get the cash from the receivables).

    2 I know that you may have read that an ideal current ratio is 2:1, but this is rubbish. There is no ‘ideal’ ratio – it depends a lot on the type of business.
    However, you would certainly want it to be greater than 1. Just suppose that you collected receivables in one month and you paid your receivables in 1 month – that is fine in that (hopefully) the money comes in from receivables in time to be able to pay your payables. However, what about inventory? It will take time to sell the inventory, then you have to wait to collect the money from the receivables, but how will you pay your payables? :-)


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    Oscar
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    Thank you :) I understand them now.

    By the way, I saw in the book that a company can finance working capital with bank overdraft. Why is this? In overdraft, cash (current asset) increases and overdraft (current liabilities) will increase by the same amount. Since working capital is current asset minus current liabilities, working capital remains the same so how can overdraft finance working capital? I had this question for more than a year and I really hope can be solved. :(


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    John Moffat
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    Think about this:

    suppose I have inventory of 10,000, receivables of 20,000, cash of 5,000, and payables of 10,000.
    That means that from somewhere I have to finance a total of (10000+20000+5000-10000 =) 25,000.

    Where is this 25000 going to come from?
    I can either finance it by having more long-term borrowing, or I can finance it by going overdrawn by 25,000.

    There are good reasons both ways as to where I should get the finance from!

    The working capital is the money needed to run the business from day-to-day (inventory + receivables + cash – payables). Where this money comes from is the choice of the company – either from short-term borrowings (overdraft) or from long-term borrowings.

    It might help you to watch my Introductory lecture to F9 (and my first lecture on working capital).


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    Oscar
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    Is working capital current asset minus current liabilities or only confined to cash+receivable+inventory-payable?


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    John Moffat
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    Working capital for F9 is how I defined it in my previous answer!!
    Inventory + receivables + cash – payables.

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