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
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.
What does working capital ratio tell you about a company? ›
Working Capital Ratio is a measure of business liquidity, calculated simply by dividing your business's total current assets by its total current liabilities. In other words, it measures the health of your company's short term finances.
What does working capital management refer to quizlet? ›
Working capital management. refers to the efficient and effective utilization of working captial to attain predetermined objectives of an organization.
What is working capital in working capital management? ›
Working capital is known as the capital that a company uses or requires to finance its day-to-day operations. It is made up of the company's current assets (such as cash, inventory, and accounts receivable) and current liabilities (such as accounts payable, short-term loans, and accrued expenses).
What is working capital current 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 1 means current assets exceed liabilities.
What is the working capital turnover ratio formula? ›
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.
What does capital ratio tell us? ›
The capital adequacy ratio (CAR) is an indicator of how well a bank can meet its obligations. Also known as the capital-to-risk weighted assets ratio (CRAR), the ratio compares capital to risk-weighted assets and is watched by regulators to determine a bank's risk of failure.
What is the goal of working capital management? ›
The goal of working capital management is to maximize operational efficiency. Efficient working capital management helps maintain smooth operations and can also help to improve the company's earnings and profitability.
What are the benefits of working capital ratio? ›
Working capital is important for a business as it helps undertake sound decisions. Working capital helps calculate the day-to-day fund requirements. It helps the company evaluate its existing fund situation. A company can thus decide effectively on the amount and source of funds.
What is working capital management managing ___________? ›
Working capital management is the process of managing current assets and liabilities to ensure the short-term liquidity of your firm.
Working capital management requires monitoring a company's assets and liabilities to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations. Managing working capital primarily revolves around managing accounts receivable, accounts payable, inventory, and cash.
What does working capital management focus on? ›
Working capital management represents the relationship between a firm's short-term assets and its short-term liabilities. It aims to ensure that a company can afford its day-to-day operating expenses while also investing the company's assets in the most successful direction possible.
What is the main function of working capital? ›
Working capital is a financial metric that is the difference between a company's curent assets and current liabilities. As a financial metric, working capital helps plan for future needs and ensure the company has enough cash and cash equivalents meet short-term obligations, such as unpaid taxes and short-term debt.
What is working capital answer in one sentence? ›
Working capital is referred to as the capital that is essential for running the day to day operations of a business. Therefore, it is the difference between current liabilities and current assets.
How to 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.
What does a working capital ratio of 1.5 mean? ›
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. An increasingly higher ratio above two is not necessarily considered to be better.
How do you calculate working capital? ›
The working capital calculation is:
- Working Capital = Current Assets - Current Liabilities.
- Net working capital = current assets (minus cash) - current liabilities (minus debt)
- Net working capital = accounts receivable + inventory - accounts payable.
The capitalization ratio formula consists of dividing a company's total debt by its total capitalization, which is the sum of its total debt and total equity. When attempting to identify the specific line items that qualify as debt, all interest-bearing securities with debt-like characteristics should be included.
What is the formula for the stock to working capital ratio? ›
The inventory to working capital ratio is calculated by dividing the inventory is paid for by the working capital value.
