Why is Current Ratio a better measure of a firms liquidity than Working Capital?

Question

I've put :

Current ratio is a better measure of a firm’s liquidity than working capital because it shows exactly how much money a business has to pay bills for every pound of assets.

But I need more detail.

Can anyone help?

Answer 1

The Current Ratio is a popular measure for a firm's liquidity. It is measured via dividing the Assets of a company by its Liquidity. This ratio shows us how much the firm has to pay its debts for every pound of assets. Conversely, the Working Capital is useful for investors because it shows how efficient a firm is. It is calculated via the following calculation, Current Assets - Current Liabilities. Positive Working Capital means the company can pay off its short-terms debt. Negative Working Capital means the company is currently unable to meet its short-term liabilities with its current assets.

There are however flaws with some of the calculations. Not necessarily flaws but that the ratio does not give the whole story. The Current Ratio is rather naive in calculation as it assumes that it will take every asset stored to meet its liabilities. This is not the case in many cases. Fuel is only added to the fire seeing that liabilities for different firms are paid off at different times. To offset these minor errors, many investors will use other Liquidity measures such as the CCC (Cash Conversion Cycle) and/or the Quick Ratio which excludes inventories from the Current Assets and then divides that sum by its liabilities.

Working Capital also does not generally show how a firm is efficient. It does not take into account its Return on Equities (ROE for short). However, it is generally regarded as a good, quick indicator.