# Optimum Working Capital
## Why It Matters
If current assets do not exceed current liabilities, the firm may struggle to satisfy creditors who want quick payment. Failure to meet short-term obligations damages reputation and discourages vendors from doing business with the firm.
Both excessive and inadequate working capital are dangerous:
- Too high → inefficient use of funds, idle assets, lost return.
- Too low → liquidity crisis, stock-outs, loss of goodwill.
## Indicators of the Working Capital Situation
### Current Ratio
$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$
- Traditionally the best single indicator of working capital health.
- A ratio of 2 for a manufacturing firm is taken to imply an optimum amount of working capital.
- A higher ratio may signal inefficient use of funds; a lower ratio may signal liquidity problems.
### Quick Ratio (Acid Test Ratio)
$$\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}$$
where Quick (liquid) Assets = Current Assets − Inventory − Prepaid Expenses.
- Should be at least 1, implying a comfortable liquidity position (liquid assets equal current liabilities).
- Supplements the current ratio.
## 'Optimum' is Situation-Specific
There is no universal optimum — it depends on the particular circumstances:
- Where inventories are easily saleable and debtors are as good as cash, the current ratio may be below 2 and the firm can still be sound.
- For perishable finished goods (e.g., a restaurant), large working capital cannot be afforded.
- For products with a longer production time, a higher amount of working capital is needed.
## Key Takeaway
A current ratio of 2 and quick ratio of 1 are benchmarks, not rules. The right level is whatever lets the firm meet obligations smoothly while keeping funds productively employed.