Businesses don't go bankrupt just because they're not profitable. Most business bankruptcies occur because the company's cash reserves ran dry, and they can't meet their current payment obligations. An otherwise profitable company may also run out of cash because of the increasing capital requirements of new investments as they grow.
There are several useful metrics that can help a company avoid these pitfalls. Working capital refers to the difference between a company's current assets and current liabilities. The working capital ratio compares these figures as a percentage. Both metrics can be useful in assessing the financial health of a company.
Key Takeaways
- Working capital and the working capital ratio are both measurements of a company's current assets as compared to its current liabilities.
- The working capital ratio is calculated by dividing current assets by current liabilities. This figure is useful in assessing a company's liquidity and operational efficiency.
- A working capital ratio below one suggests that a company may be unable to pay its short-term debts.
- Conversely, a working capital ratio that is very high suggests that a company is not effectively managing excess cash flow, which could be better directed towards company growth.
- Some analysts believe that the ideal working capital ratio is between 1.5 and 2.0, but this may vary from industry to industry.
Using the Working Capital Ratio
The working capital ratio reflects a company's operational efficiency and the health of its short-term finances. The working capital ratio is calculated by dividing the company's current assets by its current liabilities:
WorkingCapitalRatio=CurrentLiabilitiesCurrentAssets
A high working capital ratio means that the company's assets are keeping well ahead of its short-term debts. A low value for the working capital ratio, near one or lower, can indicate that the company might not have enough short-term assets to pay off its short-term debt.
Most major projects require an investment of working capital, which reduces cash flow. Cash flow will also be reduced if money is collected too slowly, or if sales volumes are decreasing, which will lead to a fall in accounts receivable. Companies that are using working capital inefficiently often try to boost cash flow by squeezing suppliers and customers.
For example, if a company has $800,000 of current assets and has $1,000,000 of current liabilities, its working capital ratio is 0.80. If a company has $800,000 of current assets and has $800,000 of current liabilities, its working capital ratio is exactly 1.
Low Working Capital
If a company's working capital ratio falls below one, it has a negative cash flow, meaning its current assets are less than its liabilities. The company cannot cover its debts with its current working capital. In this situation, a company is likely to have difficulty paying back its creditors. If a company continues to have low working capital, or if cash flow continues to decline, it may have serious financial trouble. The cause of the decrease in working capital could be a result of several different factors, including decreasing sales revenues, mismanagement of inventory, or problems with accounts receivable.
High Working Capital
An excessively high working capital is not necessarily a good thing either, since it can indicate the company is allowing excess cash flow to sit idle rather than effectively reinvesting it in company growth. Most analysts consider the ideal working capital ratio to be between 1.5 and 2. As with other performance metrics, it is important to compare a company's ratio to those of similar companies within its industry.
FAQs
Key Takeaways
What is the working capital ratio and capital ratio? ›
The current ratio is represented by a number and determines a business's current assets in excess of its current liabilities. The working capital, on the other hand, is an absolute dollar amount and determines the cash and other liquid assets a business has to cover its short-term debts.
Where do you find working capital ratio? ›
To calculate this, you should divide your current assets by your current liabilities. So, using the same figures from before ($150,000 in assets and $75,000 in liabilities) would produce a working capital ratio of 2.
Are three ratios that are important in working capital management the working capital ratio or current ratio? ›
Three ratios that are important in working capital management are the working capital ratio, the collection ratio, and the inventory turnover ratio.
What is the working ratio? ›
The working ratio measures a company's ability to recover operating costs from annual revenue. It is calculated by taking total annual expenses, excluding depreciation and debt-related expenses, and dividing it by the annual gross income.
What is the formula for capital ratio? ›
Capital adequacy ratio: Formula and computation
The capital adequacy ratio is computed by dividing the total capital of a bank by its risk-weighted assets.
Why do we calculate working capital ratio? ›
The working capital ratio is a very basic metric of liquidity. It is meant to indicate how capable a company is of meeting its current financial obligations and is a measure of a company's basic financial solvency.
How do you calculate current working capital ratio? ›
The current ratio, also known as the working capital ratio, provides a quick view of a company's financial health. You can calculate the current ratio by taking current assets and dividing that figure by current liabilities. A ratio above one means that current assets exceed liabilities.
What is working capital and how is it calculated? ›
Working capital is calculated by subtracting current liabilities from current assets, as listed on the company's balance sheet. Current assets include cash, accounts receivable and inventory. Current liabilities include accounts payable, taxes, wages and interest owed.
How do you calculate capital labor ratio? ›
The capital-labour ratio in this case can be calculated based on the value of the machinery divided by the number of workers, indicating the amount of capital available per worker.
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.
How much working capital is too much? ›
1.0 to 2.0: Short-term liquidity is optimal. The company is on firm financial footing and has positive working capital. 2.0 and above: While high working capital is definitely preferable to low in most cases, a current ratio that's too high can actually be a sign of underutilized capital.
Is lower or higher working capital better? ›
Broadly speaking, the higher a company's working capital is, the more efficiently it functions. High working capital signals that a company is shrewdly managed and also suggests that it harbors the potential for strong growth.
What is a bad working capital ratio? ›
Below 1, a business is operating with a net negative working capital position. On the other hand, a working capital ratio that strays above 2 can also be seen as unfavorable, representing that the business is hoarding too much cash and not investing proactively enough in growth.
How to determine if working capital is sufficient? ›
Current ratio
Current Assets divided by current liabilities. Your current ratio helps you determine if you have enough working capital to meet your short-term financial obligations. A general rule of thumb is to have a current ratio of 2.0.
What is working capital for dummies? ›
What Is Working Capital? Working capital, also known as net working capital (NWC), is the difference between a company's current assets—like cash, accounts receivable/customers' unpaid bills, and inventories of raw materials and finished goods—and its current liabilities, such as accounts payable and debts.
What is the capital ratio rule? ›
Financial regulators adopted stricter rules to make sure that banks meet capital requirements. One of these is maintaining a tier 1 capital ratio of 6%. This ratio is determined by dividing a bank's tier 1 capital by the total risk-weighted assets. A bank is considered capitalized if it meets this threshold.
What is NWC formula? ›
NWC = current assets - current liabilities: This is the broadest formula that includes all current assets and liabilities, such as cash, accounts receivable, inventory, accounts payable, accrued expenses, etc.
What is the WCAP ratio? ›
It shows the ratio between current assets and current liabilities. The working capital ratio formula is calculated as: Working Capital Ratio = Current Assets / Current Liabilities.
What is the formula for working capital turnover ratio? ›
The working capital turnover ratio is a financial ratio that helps companies understand their efficiency in using their working capital to generate sales. It is calculated by dividing net sales by average working capital.
