A company's working capital ratio can be too high in that an excessively high ratio might indicate operational inefficiency. A high ratio can mean a company is leaving a large amount of assets sit idle, instead of investing those assets to grow and expand its business.
Understanding Working Capital
A company's working capital position indicates how financially sound the company is and how efficiently it is being managed. The working capital ratio measures liquidity and is often used in conjunction with the current ratio to gauge a company's ability to handle short-term obligations.
The working capital ratio is calculated by dividing current assets by current liabilities. For this calculation, current assets are assets a company reasonably expects to be converted into cash within one year or one business cycle. This includes items such as inventory, accounts receivables, and cash or cash equivalents. Current liabilities include accounts payables, leases, income taxes and payable dividends.
An examination of working capital takes into account key elements of a company's basic business operations, such as inventory, accounts receivables and accounts payables. How well a company manages each element is ultimately reflected in the company's working capital ratio. Exceptionally efficient or inefficient handling of any of these basic operations impacts a company's working capital position.
Assessing Working Capital Management
A working capital ratio of 1.0 indicates a company's readily available financial assets exactly match its current short-term liabilities. While a ratio of 1.0 indicates a company should be able to adequately meet its short-term obligations, analysts prefer to see a ratio higher than 1.0, indicating the company has excess working capital left over beyond just being able to pay its expenses. Excess working capital provides some cash cushion against unexpected expenses and can be reinvested in the company's growth. A ratio below 1.0 is unfavorable, as it indicates the company's current assets are not sufficient to cover near-term obligations.
A working capital ratio somewhere between 1.2 and 2.0 is commonly considered a positive indication of adequate liquidity and good overall financial health. However, a ratio higher than 2.0 may be interpreted negatively. An excessively high ratio suggests the company is letting excess cash and other assets just sit idle, rather than actively investing its available capital in expanding business. This indicates poor financial management and lost business opportunities.
FAQs
A company's working capital ratio can be too high in that an excessively high ratio might indicate operational inefficiency. A high ratio can mean a company is leaving a large amount of assets sit idle, instead of investing those assets to grow and expand its business.
Do you want working capital to be high or low? ›
A positive working capital ratio is important for a business to be able to operate effectively. It means that the business has the ability to repay more than the total value of its current liabilities. The higher the working capital ratio, the greater the ability of the company to pay its liabilities.
What happens when you have too much working capital? ›
Having an abundance of working capital results in unused funds that don't generate profits for the business, thereby preventing the business from achieving a satisfactory return on its investments.
How much working capital is enough? ›
Generally, a working capital ratio of less than one is taken as indicative of potential future liquidity problems, while a ratio of 1.5 to two is interpreted as indicating a company is on the solid financial ground in terms of liquidity.
What are the pros and cons of high working capital? ›
The pros of a high working capital ratio are: ~Reduced risk of defaulting on short-term obligations ~Improved credit rating and lower borrowing costs ~More flexibility to invest in growth opportunities ~Stronger bargaining power with suppliers and customers The cons of a high working capital ratio are: ~Lower returns ...
What causes excessive working capital? ›
High working capital isn't always a good thing. It might indicate that the business has too much inventory, is not investing its excess cash, or is not taking advantage of low-cost debt opportunities.
Why would a company want a high working capital? ›
Extra working capital can help improve your business in other ways. For example, it may enable you to take advantage of supplier discounts by using cash on hand to purchase in bulk. This can save you the interest you might have to pay using a credit card, which could be higher than for other types of credit.
What are the disadvantages of excessive working capital? ›
(i) Excessive Working Capital leads to unnecessary accumulation of raw materials, components and spares. (ii) Excessive Working Capital results in locking up of excess Working Capital. (iii) It creates bad debts, reduces collection periods, etc. (iv) It leads to reduce the profits.
Should operating working capital be high or low? ›
High and low OWC show how efficiently a company is using and managing funds. OWC directly affects the amount of cash available to a company. A high OWC usually means that a company has less cash because it was used to fund its operating cycle.
What is a good working capital? ›
A good working capital ratio (remember, there is no difference between current ratio and working capital ratio) is considered to be between 1.5 and 2, and suggests a company is on solid ground.
Why Reduce Working Capital Cycle? The reduction in capital cycle has two major consequences: freeing up trapped capital and generating more margin and profitability. Think of inventory as a capital storage. Businesses invest capital in their products and this capital is trapped until the day they sell their products.
Does high amount of working capital reduce profitability? ›
As the amount of working capital increases, the liquidity of the business increases. However, since current assets offer low return, with the increase in working capital the profitability of the business falls.
Why should working capital not be too high? ›
Funds tied up in working capital tend to earn little, or no, return. Hence, a company with a high level of working capital may fail to achieve the return on capital employed (Operating profit ÷ (Total equity and long-term liabilities)) expected by its investors.
Is it better to have more or less working capital? ›
But a deficit of working capital could signal a potential bankruptcy. Usually, the greater a company's capital is, the better. It means their liquid assets (those that can be turned into cash within a year) outweigh their liabilities, such as payroll, debts, taxes, or other liabilities (due in the next 12 months).
What is reasonable working capital? ›
Reasonable Working Capital means an amount reasonably determined by Manager at the same time as the monthly financial statements are prepared pursuant to Section 15.02 hereof, but in no event to exceed a sum equal to a ratio of current assets to current liabilities of 2:1 (but excluding from such calculation cash ...
Is it bad to have a high net working capital? ›
Net Working Capital as An Indicator of Efficiency
In particular, the time it takes collecting dues from your customers might be taking too long. On the opposite end of the spectrum, when net working capital is excessive it is an indication that the business is not managing its cash and short-term assets effectively.
What is considered a high working capital turnover? ›
Experts say that a capital turnover ratio calculation of 1.5 to 2.0 is good. Higher is also better to a certain extent. If the number is too high, it's a working capital indicator that your available funds are too low.
Is a high operating working capital good or bad? ›
In practical terms, this means it has money left to be spent on day-to-day operations or to invest in growth. Although having positive working capital is a good indication of performance, excessively high working capital might also indicate that the company is not optimising its operations.
