## What is Working Capital Ratio?

The working capital ratio measures the short term liquidity position of the company and tries to assess quantitatively whether the company will be able to pay off its short term liabilities (current liabilities) with the help of short term liquid assets (current assets).

### Working Capital Ratio Formula

Working Capital Ratio Formula= 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 negative working capital which generally means that the company is unable to pay its liabilities. A consistently negative working capital 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. This 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 Example

** **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.

### Components

Let us look at the key components of working capital ratio – Current Assets and Current Liabilities.

#### Current Assets:

In general words, current assets include cash and other assets that can be converted to cash within a year’s span.

source: Colgate 2015 10K

Examples of current assets are:

- Short term investment in mutual funds
- Accounts receivable
- Inventory (Consists of raw materials, work-in-progress and finished goods)
- Bank balance

#### Current Liabilities:

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 payable
- Notes payable (due within a year)
- Other expenses are generally payable in a month’s time such as salary, material supply, etc.

Let us calculate from working Capital for Colgate from the images above.

Here, Current Assets = Cash and Cash Equivalents + Accounts Receivables + 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 Ratio

### 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 |

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 which can be obtained from a company’s balance sheet. This 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 period (A/cs Receivable) | 30 days | 120 days |

Average payment period (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 the liquidity. The following other financial indicators are also required:

- Days inventory outstanding formula = Cost of sales per day ÷ Average inventories
- Days sales outstanding formula = 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.

### Working Capital Ratio Video

### Useful Post

- Examples of Accruals Concept in Accounting
- How to create a Project Timeline in Excel?
- Cash Conversion Cycle Formula Example
- Accrued Income Journal Entries
- What is the Timeline in Excel?
- Fundamental Analysis Guide
- Current Ratio Example
- Quick Ratio vs Current Ratio
- Cash Conversion Cycle Example
- Asset Turnover Ratio Example
- Equity Turnover Ratio Example
- Cash Ratio Example

khalid iqbal says

such an outstanding work! very beneficial blog for accounting students. thanks alot sir.

Dheeraj Vaidya says

thanks Khalid!

Cole Burns says

You are doing an outstanding job. I read all your blogs and till now I liked all the blogs which you have posted Thanks and keep posting. I have a question related to working capital. We should aim for a higher working capital or lower?

Dheeraj Vaidya says

thank you Cole! I am glad that you read my blogs and also you like those thanks. I will be happy to answer your question.

Working capital usually helps you to understand how the company or an organization will perform over the next one year. The higher working capital means that your cash generated for next year will be higher well the lower working capital means that you will generate cash this year itself. If the working capital is lower this means that company need to pay more money that it will generate over the next one year. You should normally target an optimal level of working capital which is not low and not too high either!

Julian Todd says

I must say this is a great post and very useful. Can you tell me what exactly liquidity ratio is? Are there any types?

Dheeraj Vaidya says

Thanks Julian!To tell you about Liquidity ratio, it measures how the liquid assets of a company are easily converted into cash as compared to its current liabilities. And there are 3 types of liquidity ratios – Acid Ratio, (quick asset ratio), and the other is current ratio and the last one is cash ratios.

Dr.RATNESHWAR PRASAD SINHA says

This is the best way solution on working Working Capital Ratio|Formula | Management | Financing. This is informative articles for all.

Dheeraj Vaidya says

Thanks Dr. Ratenshwar for your kind words!