Working Capital Ratio

Working Capital Ratio Meaning

The working capital ratio is the ratio that helps in assessing the financial performance and the health of the company, where a ratio of less than 1 indicates the probability of financial or liquidity problems in the future for the company. It is calculated by dividing the total current assets of the company with its total current liabilities.

You are free to use this image o your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Working Capital Ratio (wallstreetmojo.com)

The net working capital ratio, a key financial metric, measures a company’s short-term liquidity and ability to cover its immediate liabilities. It’s a crucial indicator of financial health, helping stakeholders assess an organization’s operational efficiency and sustainability. A high ratio indicates ample liquidity, while a low one may signal potential financial stress.

Working Capital Ratio Explained

The working capital ratio, often referred to as the current ratio, is a fundamental financial metric that plays a vital role in assessing a company’s short-term financial health and operational efficiency. It provides valuable insights into an organization’s ability to meet its short-term obligations and manage its day-to-day operations effectively.

The working capital ratio is calculated by dividing a company’s current assets by its current liabilities. Current assets include cash, accounts receivable, inventory, and other assets that are expected to be converted into cash within a year. Current liabilities encompass short-term obligations such as accounts payable, short-term debt, and other liabilities due within the next 12 months.

A ratio above 1 indicates that the company has more current assets than current liabilities, signifying a healthy liquidity position. This means that the company is well-positioned to meet its short-term financial obligations. Conversely, a ratio below 1 suggests that the company may face difficulties in covering its short-term liabilities and may need to rely on external financing or asset liquidation.

For investors and creditors, the working capital ratio serves as a crucial indicator of an organization’s financial stability and its ability to repay debts. A higher ratio generally instills confidence, as it implies a cushion of liquidity, reducing the risk of default. However, an excessively high ratio may also indicate that the company is not efficiently utilizing its resources. On the other hand, a low ratio may raise concerns about financial risk and the company’s ability to meet its obligations on time.

Hence, the working capital ratio analysis is a significant tool for assessing the short-term financial viability and liquidity of a company. It helps management make informed decisions about resource allocation, and it assists investors and creditors in evaluating an organization’s creditworthiness and financial stability.

Formula

Let us understand the formula that shall act as a basis to find the net working capital ratio through the discussion below.

Working Capital Ratio = Current Assets ÷ Current Liabilities

Generally speaking, it can be interpreted as follows:

• If this ratio is around 1.2 to 1.8 – This is generally said to be a balanced ratio, and it is assumed that the company is in a healthy state to pay its liabilities.
• If it is less than 1 – It is known as negative working capital, which generally means that the company cannot pay its liabilities. A consistently negative working capitalNegative Working CapitalNegative Working Capital refers to a scenario when a company has more current liabilities than current assets. It implies that the available short-term assets are not enough to pay off the short-term debts. read more may also lead to bankruptcyBankruptcyBankruptcy refers to the legal procedure of declaring an individual or a business as bankrupt.read more. (Detailed explanation is given in a later segment)
• If this ratio is greater than 2 – the Company may have excess and idle funds that are not utilized well. It should not be the case as the opportunity cost of idle funds is also high.

However, these ratios generally differ with the industry type and will not always make sense.

Working Capital Ratio Video

Examples

Now that we understand the basics, formula, and related factors of working capital ratio analysis, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

LMN Corporation’s management decided to undergo a series of infrastructural developments. However, it came to light much later that the company did not have the desired amount of funds at its disposal for such an extensive expansion.

The top management of the company came together to assess the situation. They found that the account receivables and the other current assets were at $600,000. However, the infrastructural development project would cost them approximately $1 million.

To ensure the company could function and did not go bankrupt, they decided to put a hold on the developmental activities until they had sufficient funds and employed the funds at their disposal to procure raw materials and marketing instead.

Example #2

 Sears Holding stock fell by 9.8% due to continuing losses and poor quarterly results. Sears’s balance doesn’t look too good, either. Moneymorning has named Sears Holding one of the five companies that may go bankrupt soon.

Especially if you check the working capital situation of Sears Holdings and calculate the working capital ratio, you will note that this ratio has been decreasing continuously for the past ten years or so. This ratio below 1.0x is not good.

Components

Let us look at the critical components of working capitalComponents Of Working CapitalMajor components of working capital are its current assets and current liabilities, and the difference between them makes up the working capital of a business. The efficient management of these components ensures the company's profitability and provides the smooth running of the business.read more ratio – Current Assets and Current Liabilities.

Current Assets:

Current assets include cash and other assets that can convert to cash within a year.

source: Colgate 2015 10K

Examples of current assets areExamples Of Current Assets AreCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more:

• Short term investment in mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more
• Accounts receivable
• Inventory (Consists of raw materials, work-in-progress and finished goods)
• Bank balance

Current Liabilities:

The company will have to pay these current liabilities within a year.

source: Colgate 2015 10K

Examples of current liabilities are:

• Accounts payableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more
• Notes payableNotes PayableNotes Payable is a promissory note that records the borrower's written promise to the lender for paying up a certain amount, with interest, by a specified date. read more (due within a year)
• Other expensesOther ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities.read more are generally payable in a month’s time, such as a salary, material supply, etc.

Let us calculate and conduct a working capital ratio analysisfor Colgate from the images above.

Here, Current Assets = Cash and Cash EquivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation.  Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more + Accounts ReceivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more + Inventories + Other Current Assets

• Current Assets (2015) = $970 + $1,427 + $1,180 + $807 = $4,384

Current Liabilities = Notes and loans payable + Current portion of long term debt + Accounts Payable + Accrued Income Taxes + Other Accruals

• Current Liabilities (2015) = $4 + $298 + $1,110 + $277 + $1,845 = $3,534

Working Capital (2015) = Current Assets (2015) – Current Liabilities (2015)

• Working Capital (2015) = $4,384 – $3,534 = $850
• Working Capital Ratio (2015) = $4,384 / $3,534 = 1.24x

This ratio is also known as Current RatioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities read more

Changes in Working Capital Ratio

As explained above, the net working capital ratio is a dynamic figure and keeps changing with the change in both assets/liabilities. The following table summarizes the effects of changes in individual components of working capital:

Components of Working Capital	Change	Effect on Working Capital
Current Assets	Increase	Increase
Decrease	Decrease
Current Liabilities	Increase	Decrease
Decrease	Increase

 Working Capital vs Liquidity

As discussed earlier, working capital is the difference between its current assets and liabilities. These are stand-alone financial figures obtained from a company balance sheet Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more. It is not proof of a company’s liquidity position.

Let us understand this with the help of an example:

Particulars	Company WC	Company Liquid
Current Assets	500	1000
Current Liabilities	500	500
Working Capital Ratio	1:1	2:1

In the above case, Company Liquid seems to be more liquid as compared to Company WC. Now, let us include some more details to the above table

Particulars	Company WC	Company Liquid
Average collection periodAverage Collection PeriodThe average collection period is the duration of time a company requires to collect all the payments dues on their clients as Accounts receivables. Average collection period = 365/Accounts Receivable turnover ratio. Alternative formula, Average collection period = Average accounts receivable per day/average credit sales per day read more (A/cs Receivable)	30 days	120 days
Average payment periodAverage Payment PeriodAverage payment period refers to the average time period taken by an organization for paying off its dues with respect to purchases of materials that are bought on the credit basis from the suppliers of the company. It doesn’t necessarily have any impact on the company’s working capital.read more (A/cs Payable)	60 days	90 days

Taking the above two stats, it is clear that Company WC will be able to generate cash in a more efficient way rather than Company Liquid. Working Capital Ratio alone is not sufficient to determine liquidity. The following other financial indicators are also required:

1. Days inventory outstanding formulaDays Inventory Outstanding FormulaDays Inventory Outstanding refers to the financial ratio that calculates the average number of days of inventory held by the company before selling it to the customers, providing a clear picture of the cost of holding and potential reasons for the delay in the inventory sale.read more = Cost of sales per day ÷ Average inventories
2. Days sales outstanding formulaDays Sales Outstanding FormulaDays sales outstanding portrays the company's efficiency to recover its credit sales bills from the debtors. The number of days debtors took to make the payment is computed by multiplying the fraction of accounts receivables to net credit sales with 365 days.read more = Net sales per day ÷ Average Accounts Receivable
3. Days payable outstanding formula = Cost of salesCost Of SalesThe costs directly attributable to the production of the goods that are sold in the firm or organization are referred to as the cost of sales.read more per day ÷ Average Accounts Payable

These measures the respective turnovers, e.g., days inventory outstanding means how many times the inventory was sold and replaced in a given year.

The three of the above indicators can measure the Cash Conversion Cycle (CCC), which tells the number of days it takes to convert net current assets into cash. Longer the cycle, the longer the business has its funds utilized as working capital without earning a return. So the business should aim to minimize the CCC as much as possible.

Cash Conversion Cycle (CCC) = Days inventory outstanding + Days sales outstanding – Days payable outstanding

The Cash Conversion Cycle (CCC) will be a better measure to determine the company’s liquidity rather than its working capital ratio.

Frequently Asked Questions (FAQs)

Recommended Articles

This article has been a guide to Working Capital Ratio and its meaning. Here, we explain the formula, components, and examples and compare it with liquidity. You can learn more about important metrics through:

• Quick Ratio vs. Current Ratio Differences
• Cash Conversion Cycle Formula
• Asset Turnover Ratio Meaning
• Equity Turnover Ratio Example