What is Working Capital Ratio?
Working capital ratio is the ratio which helps in assessing the financial performance and the health of the company where the ratio of less than 1 indicates the probability of financial or liquidity problem in future to the company and it is calculated by dividing the total current assets of the company with its total current liabilities.
Working Capital Ratio = Current Assets ÷ Current Liabilities
Generally speaking, it can be interpreted as follows:
- If this ratio around 1.2 to 1.8 – This is generally said to be a balanced ratio, and it is assumed that the company is a healthy state to pay its liabilities.
- If it is less than 1 – It is known as a negative working capital, which generally means that the company is unable to 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. may also lead to bankruptcy. (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.
Sears Holding stock fell by 9.8% on the back of continuing losses and poor quarterly results. Sears’s balance doesn’t look too good, either. Moneymorning has named Sears Holding as 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 10 years or so. This ratio below 1.0x is definitely not good.
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. ratio – Current Assets and Current Liabilities.
In general words, current assets include cash and other assets that can be converted 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.:
- Short term investment in mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.
- Accounts receivable
- Inventory (Consists of raw materials, work-in-progress and finished goods)
- Bank balance
Current liabilities are such which will be due within a year or will have to be paid within a span of one 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.
- 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. (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. are generally payable in a month’s time, such as a salary, material supply, etc.
Let us calculate from working Capital for 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. + Accounts ReceivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. + 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
Changes in Working Capital Ratio
As explained above, working capital 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|
Working Capital vs Liquidity
As discussed earlier, working capital is the difference between its current assets and liabilities. These are stand-alone financial figures which can be obtained from a company’s 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.. 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|
|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
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 the liquidity. The following other financial indicators are also required:
- 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. = Cost of sales per day ÷ Average inventories
- 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. = Net sales per day ÷ Average Accounts Receivable
- Days payable outstanding formula = Cost of sales 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 be used to 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 to it. So the business should aim to minimize the CCC as far as possible.
Cash Conversion Cycle (CCC) = Days inventory outstanding + Days sales outstanding – Days payable outstanding
Cash Conversion Cycle (CCC) will be a better measure to determine the liquidity of the company rather than its working capital ratio.