Ch11. Working Capital & Turnover Ratios — Reading Liquidity and Cash Conversion Speed

Why Study Working Capital and Turnover Ratios Separately?

The income statement answers “how much did the company earn?” The balance sheet answers “what does the company hold right now?” In practice, you need to connect both questions and ask: “how fast is cash flowing through the business?” The metrics that answer this are liquidity ratios and activity ratios.

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1. Current Ratio

The current ratio measures how comfortably a company can cover its short-term obligations.

Current Ratio = Current Assets / Current Liabilities × 100

Item	Meaning
Current assets	Assets convertible to cash or consumed within one year
Current liabilities	Obligations due within one year

Interpretation

• Around 200% is traditionally considered healthy.
• Too low signals short-term liquidity risk.
• Too high can indicate idle inventory or excess cash — not automatically good.

Example

Current Assets:      $800,000
Current Liabilities: $400,000

Current Ratio = $800,000 / $400,000 × 100 = 200%

Meaning: for every $1 owed within the year, the company holds$2 in current assets.

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2. Quick Ratio

The quick ratio removes inventory from current assets to show how well a company can cover short-term debt using only immediately liquid assets.

Quick Ratio = (Current Assets − Inventory) / Current Liabilities × 100

Inventory is classified as a current asset on the balance sheet, but it may not convert to cash quickly. The quick ratio is therefore a more conservative measure than the current ratio.

Example

Current Assets:      $800,000
Inventory:           $300,000
Current Liabilities: $400,000

Quick Ratio = ($800,000 − $300,000) / $400,000 × 100 = 125%

Meaning: even after stripping out inventory, the company still has enough to cover short-term debt.

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3. Accounts Receivable Turnover

When a company sells on credit, the money not yet collected is recorded as accounts receivable. The accounts receivable turnover ratio shows how quickly those credit sales convert to cash.

AR Turnover = Net Credit Sales / Average Accounts Receivable
Average AR = (Beginning AR + Ending AR) / 2

Interpretation

• Higher means faster collection.
• A declining ratio may indicate lax credit management or growing bad-debt risk.

Companion metric

Days Sales Outstanding (DSO) = 365 / AR Turnover

For example, a turnover of 10× means the company collects payment on average every 36.5 days.

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4. Inventory Turnover

The inventory turnover ratio shows how quickly goods sell and are replenished.

Inventory Turnover = Cost of Goods Sold / Average Inventory
Average Inventory = (Beginning Inventory + Ending Inventory) / 2

Why use COGS, not revenue?

Inventory is carried at cost on the balance sheet, so using COGS aligns the numerator and denominator on the same measurement basis.

Interpretation

• Higher means goods are selling faster.
• Too high risks stockouts.
• Too low means goods sit in the warehouse, increasing storage costs and write-down risk.

Companion metric

Days Inventory Outstanding (DIO) = 365 / Inventory Turnover

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5. Reading All Four Together

Ratio	Question it answers
Current Ratio	Can the company cover short-term obligations on paper?
Quick Ratio	Can it survive even if inventory doesn’t sell quickly?
AR Turnover	Is the company collecting its credit sales promptly?
Inventory Turnover	Is inventory moving or sitting idle in the warehouse?

All four converge on one fundamental question:

“Does this company not only generate profit but also move cash efficiently?“

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6. Standards Differ by Industry

• Retail: High inventory turnover but thinner margins.
• Manufacturing: Carries more inventory, so turnover benchmarks differ.
• Platform / software companies: Little physical inventory; rely more on DSO and cash conversion cycle.

Always compare ratios against industry peers, historical trends, and changes in working capital structure rather than using absolute numbers in isolation.

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Key Concept Cards

Current Ratio vs. Quick Ratio ★★★★★
Current ratio includes inventory; quick ratio excludes it. The quick ratio is the more conservative short-term liquidity measure.

AR Turnover ★★★★★
Measures how fast credit sales convert to cash. A declining ratio can be an early warning of cash flow problems.

Inventory Turnover ★★★★☆
Based on COGS, measures the speed of inventory depletion. Low turnover means capital is tied up in the warehouse.

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Practice Quiz

Q. The current ratio is high but the quick ratio is low. What situation might this suggest?

Inventory may be an unusually large share of current assets. The company looks liquid on paper, but actual cash conversion could be slow.

Q. Revenue is growing but AR turnover keeps falling. What does this imply?

Credit sales are being collected more slowly. Even as profits grow, cash flow risk is rising — a gap between reported earnings and actual cash received.