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.
