Superior Living Working Capital Is the Current

Superior Living

Working capital is the current assets less the current liabilities (Kennon, 2012). The working capital is an important metric because it can have a significant effect on the company's short- and long-term decision making. The working capital is affected by the cash position, the inventories and the receivables, along with the short-term liabilities. The current ratio is simply the working capital in ratio format, the current assets divided by the current liabilities (Loth, 2012). If a company has insufficient working capital, this can represent a constraint on operations. The company may need to plow all capital it earns into servicing the liabilities, leaving little for capital projects. Additionally, working capital and current ratio are measures that creditors use to evaluate how much credit to give a company. Often, these measures are also used in the company's restrictive covenants in loans as well.

Aside from the current ratio, there are two other ratios that are used, the quick ratio and the cash ratio. These exist to help distinguish between the different sources of working capital. For a company that has upcoming cash needs, it is important to know how much of our working capital is cash and how much is tied up in inventory and receivables. The latter should be relatively easy to convert to cash on short notice, but inventory may not be.

Thus, it is especially important to manage inventory levels as a means of tightening the cash conversion cycle. The cash conversion cycle is an important concept in working capital management, because it reflects how quickly things like inventory and sales are converted into cash that the company can use. By reducing levels of inventory and receivables, the company can free up more cash for other needs. Additionally, stretching payables is another way to free up extra cash. What this means is that there are opportunities with respect to working capital management for the company to ensure that it has cash when it needs it, but only if the company's financial managers are aware of the needs and plan ahead.

There are basically three different ways to handle the short-term debt that is coming due. The first is to pay it off. This will reduce the company's cash position, and it will alter the capital structure of the firm by reducing the total debt level. The second is to roll it over, by acquiring new financing in the same amount. The current debt thus becomes long-term debt. The third way to handle it is to stretch the payables, so that the total level of current liabilities increases but the company frees up more cash to make the payments. This still results in the company paying down the debt but has less of an impact on the cash position. Which option is better depends on the company's cash position. It is recommended, however, that the company know ahead of time how it intends to manage this coming liability so that if it does decide to pay it off the cash will be there.

The current ratio is the ratio of current assets to current liabilities (Loth, 2012). The higher the current ratio, the more likely the firm is to be able to pay down its debt. Any company should like to see a current ratio of 1.0, since that indicates there are more current assets than current liabilities -- that is to say there are assets that are not yet matched up with debts. For many companies, it is preferable to have a current ratio significantly higher, because inventory may not always be sold at book -- if the firm's inventory level is very high it may need to liquidate at a very low price. Thus, the quick ratio is important because it cuts out inventory, and for some companies that may have inventory they cannot move profitably this is an important measure.

Capital budgeting refers to long-term projects. In general, capital budgeting projects are evaluated using the project's net present value (NPV). This involves a calculation of the future cash flows incremental to the project and then discounts those flows back to present dollars. The discount rate is the firm's cost of capital, which is a weighted average of the firm's cost of equity and cost of debt. The company should use the WACC even if it intends to finance the project entirely by one form of capital or another.

For our company, we do need to think about how we want to finance any large projects that we want to undertake this year. Normally, the source of financing should be matched up with the nature of the project. If you have a project that is five years in length and only generates revenues over that time, a five-year loan is the best source of financing because the cash flows from the project can be put directly to debt service. If the project has an infinite life, equity financing is ideal. This can be accomplished, for example, by rolling over the loan coming due this year and using our ongoing free cash flow to finance the project.