What is working capital ratio?
Working capital ratio is a measurement that shows a business’s current assets as a proportion of its liabilities. It’s a metric that provides an overview of financial health and liquidity, indicating whether current liabilities can be paid by existing assets.
In the case of working capital ratio, assets are typically defined as cash, inventory, accounts receivable, and short-term investments. Liabilities are the business’s debts, including accounts payable, loans, and wages.
Therefore, working capital ratio is a measure of whether a business is operating with a net positive or negative working capital position. Represented as a ratio, if the figure is 1 or above, the business has net positive working capital. If it’s below 1, the business has net negative working capital.
Working capital ratio is one of the most common ways of representing working capital position, alongside net working capital (which is simply current assets minus current liabilities).
It is a leading indicator of a business’s ability to pay its short-term financial obligations, a capability directly associated with operational health. It also has ramifications on other parts of business, including as a factor considered by creditors and lenders who are being asked to extend lines of credit.
It can be tracked over time to gauge changes in working capital position on a relative basis. The ratio increasing over time is generally a sign of an improved working capital position and vice versa.
How to calculate working capital ratio
Working capital ratio is calculated by dividing all current assets by current liabilities. The formula is:
Working capital ratio = Current assets / current liabilities
For example, if a business has $1,000,000 in current assets and $500,000 in current liabilities, its working capital ratio would be calculated as:
1,000,000 / 500,000 = 2
Working capital ratio is sometimes known as current ratio. This reflects the fact that it factors in current assets and current liabilities, which are generally defined as being able to be converted into cash within a year.
Businesses tend to calculate working capital ratio on a regular basis due in part to its ability to reflect working capital position changes over time accurately.
Interpreting working capital ratio
Working capital ratio can be interpreted relatively simply. The ratio refers to the proportional relationship between assets and liabilities. When working capital ratio is above 1, a business can theoretically pay off all its liabilities with its existing assets.
When it’s below 1, the opposite is true. With a working capital ratio of 0.99 or less, a business would have to find additional funds from elsewhere to cover all its liabilities, even after using all of its current assets.
However, it’s worth noting that working capital ratio can be influenced by temporary factors and is sometimes misleading. Businesses that are growing fast and investing big by extending credit lines might have a low working capital ratio, but when the growth pays off, they will be in a much stronger position.
As another example, businesses with extremely high inventory turnover rates can sometimes afford to maintain what might otherwise be considered a poor working capital ratio for long periods because they have very short cash conversion cycles.
These reasons, and more, are why it’s important to look at working capital ratio in context. It isn’t particularly helpful as a single metric viewed in a vacuum but is an important part of measuring financial health alongside other metrics.
What is a good working capital ratio?
Generally, a higher working capital ratio is seen as positive, while a lower one is seen as negative. Businesses will tend to aim for a working capital ratio between 1.2 and 2.
Slipping below 1.2 could mean the business will struggle to pay its bills, depending on its operating cycle and how quickly it can collect receivables. 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.
However, the specifics depend on a huge range of factors – including the sector a business operates in, how established it is, and whether it is in a growth period.
Improving working capital ratio
Working capital ratio can be improved by improving your working capital position. There are essentially two ways of doing this:
- Increasing the amount of money coming into the business and the speed with which it’s collected
- Decreasing the amount of money leaving the business and the speed with which it’s let go of
One method of achieving the first objective is to increase the efficiency of accounts receivable processes. Renegotiating payment terms with your customers to collect money more quickly, deploying solutions like early payment programs or accounts receivable financing, and improving how well you can communicate with suppliers can all make this possible.
The latter objective can be achieved by doing the same on the accounts payable side of operations. That involves renegotiating payment terms with suppliers to extend the amount of time you have to pay debts, using dynamic discounting or supply chain finance, and streamlining accounts payable processes.
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