Working Capital Ratio

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.

Formula

Working Capital Ratio = Current Assets ÷ Current Liabilities

Generally speaking, it can be interpreted as follows:

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

Working Capital Ratio

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For eg:
Source: Working Capital Ratio (wallstreetmojo.com)

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 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:

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

working-capital-current-assets

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:

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.

working-capital-current-liabilities

source: Colgate 2015 10K

Examples of current liabilities are:

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

Here, Current Assets = Cash and Cash Equivalents + 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.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, 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 CapitalChangeEffect on Working Capital
Current AssetsIncreaseIncrease
DecreaseDecrease
Current LiabilitiesIncreaseDecrease
DecreaseIncrease

 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. It is not proof of a company’s liquidity position.

Let us understand this with the help of an example:

ParticularsCompany WCCompany Liquid
Current Assets5001000
Current Liabilities500500
Working Capital Ratio1:12:1

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

ParticularsCompany WCCompany 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 days120 days
Average payment period (A/cs Payable)60 days90 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:

  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 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

 

Reader Interactions

Comments

  1. khalid iqbal says

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

    • Dheeraj Vaidya says

      thanks Khalid!

  2. 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!

  3. 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.

  4. 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.

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