The ability of a business to meet its short-term cash requirements is called liquidity. It is affected by the timing of a company’s cash inflows and outflows along with prospects for future performance. Efficiency refers to how productive a company is in using its assets, and it is usually measured relative to how much revenue is generated from a particular level of assets. They are both important and complementary.
Two measures for evaluating a business’s short-term liquidity are working capital and the current ratio. Working capital is the dollar amount of a company’s current assets less current liabilities as shown below:
Working capital = Current assets – Current liabilities
An excess of the current assets over the current liabilities implies that the company is able to pay its current liabilities. If the current liabilities are greater than the current assets, the company may not be able to pay its debts and continue in business. The current ratio is another means of expressing the relationship between current assets and current liabilities. The current ratio is computed by dividing current assets by current liabilities, as shown below.
Current ratio = Current assets/Current liabilities
The current ratio enables one to compare the liquidity of different-sized companies and
of a single company at different times. Both of these financial measures become even
more relevant when comparing your present results to those of previous years.
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