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.In determining working capital, also known as net working capital, or the working capital ratio, companies rely on the current assets and current liabilities figures found on their financial statements or balance sheets.
Determininga Good Working Capital Ratio
The ratio is calculated by dividing current assets by current liabilities. It is also referred to as the current ratio.
Generally, a working capital ratio of less than oneis taken as indicative of potential future liquidity problems, while a ratio of 1.5 to twois interpreted as indicating a company is on the solid financial ground in terms of liquidity.
An increasingly higher ratio above twois not necessarily considered to be better. Asubstantially higher ratio can indicate that a company is not doing a good job of employing its assets to generate the maximum possible revenue. A disproportionately high working capital ratio is reflected in an unfavorable return on assets ratio (ROA), one of the primary profitability ratios used to evaluate companies.
What Does the Working Capital Ratio Indicate About Liquidity?
Liquidity is critically important for any company. If a company cannot meet its financial obligations, then it is in danger of bankruptcy, no matter how rosy its prospects for future growth may be. However, the working capital ratio is not a truly accurate indication of a company's liquidity position. It simply reflects the net result of the total liquidation of assets to satisfy liabilities, an event that rarely actually occurs in the business world. It does not reflect additional accessible financing a company may have available, such as existing unused lines of credit.
Traditionally, companiesdo not access credit lines for more cash on hand than necessary asdoing so would incur unnecessary interest costs.However,operating on such a basis may cause the working capital ratio to appear abnormally low. Nonetheless, comparisons of working capital levels over time can at least serve as potential early warning indicators that a company may have problems in terms of timely collection of receivables that, if not addressed, could lead to a future liquidity crisis.
Measuring Liquidity Through the Cash Conversion Cycle
An alternative measurement that may provide a more solid indication of a company's financial solvency is the cash conversion cycle or operating cycle. The cash conversion cycle provides important information on how quickly, on average, a company turns over inventory and converts inventory into paid receivables.
Since slow inventory turnover rates or slow collection rates of receivables are often at the heart of cash flow or liquidity problems, the cash conversion cycle can provide a more precise indication of potential liquidity problems than the working capital ratio. The working capital ratio remains an important basic measure of the current relationship between assets and liabilities.
Correction—Nov. 30, 2022: This article previously misstated that the working capital ratio appears on the bottom line of a company's balance sheet. It has been edited to note that working capital and the working capital ratio are derived from the current assets and current liabilities figures found on financial statements or balance sheets.
FAQs
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 is the ideal working capital ratio? ›
Most analysts consider the ideal working capital ratio to be between 1.5 and 2.
Is 1.2 a good working capital ratio? ›
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.
What is an acceptable capital ratio? ›
Understanding CAR. The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets. Currently, the minimum ratio of capital to risk-weighted assets is 8% under Basel II and 10.5% (which includes a 2.5% conservation buffer) under Basel III.
What is a bad working capital ratio? ›
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.
Should working capital ratio be high or low? ›
A higher working capital ratio usually demonstrates a healthier financial position and a better capacity to repay short-term liabilities with short-term assets.
Do you want a high or low working capital ratio? ›
For many small businesses, a working capital ratio between 1.5 and 2 is ideal. Again, you don't want your working capital to be too low, as you may be unable to meet your short-term obligations in that case.
Is 4 a good working capital turnover ratio? ›
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. You need to build up more capital.
What is a high capital ratio? ›
A bank with a high capital adequacy ratio is considered to be above the minimum requirements needed to suggest solvency. Therefore, the higher a bank's CAR, the more likely it is to be able to withstand a financial downturn or other unforeseen losses.
What is a high working capital? ›
If a company has very high net working capital, it generally has the financial resources to meet all of its short-term financial obligations. Broadly speaking, the higher a company's working capital is, the more efficiently it functions.
Working Capital Ratio = Current Assets ÷ Current Liabilities
For example, if your business has $500,000 in assets and $250,000 in liabilities, your working capital ratio is calculated by dividing the two. In this case, the ratio is 2.0.
Is 1.3 a good working capital ratio? ›
Determining a Good Working Capital Ratio
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.
Is a 1.1 current ratio good? ›
A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts. A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term liabilities.
Is a high working capital good or bad? ›
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 if the current ratio is less than 1? ›
What Happens If the Current Ratio Is Less Than 1? As a general rule, a current ratio below 1.00 could indicate that a company might struggle to meet its short-term obligations, whereas ratios of above 1.00 might indicate a company is able to pay its current debts as they come due.
