Working capital ratio is an indicator of the short term financial credibility of a company. The following article explains the procedure to calculate the same.
Working capital is the liquid capital available with the company to carry on its day-to-day activities. It is the difference between the current assets and the current liabilities of a company. To understand what is working capital ratio, a proper understanding of the current assets and current liabilities is very essential. These entities and some other related terms are explained in the paragraphs below.
Current Assets and Current Liabilities
They are the short-term assets of a company, which are utilized within one year. Cash, accounts receivable, inventory, short-term investments, and prepaid expenses constitute the current assets of a company.
Current liabilities are the short term liabilities of a company, which are settled within one year. Accounts payable, outstanding expenses, payable taxes, and short-term loans constitute the current liabilities of a company.
Working Capital Ratio
Working capital ratio is calculated to know whether a business has sufficient short term assets to meet its short term liabilities. The mathematical formula for calculating it is:
Working capital ratio = current assets / current liabilities
Let’s take an example of a fictitious company named “Tensa International”, to learn how to calculate working capital ratio. Suppose the current assets of Tensa International are USD 200,000 and the current liabilities are USD 150,000, then the working capital ratio for Tensa International is calculated as current assets / current liabilities, that is, USD 200,000 / USD 150,000, which is 1.33.
Ideally, the working capital ratio should be somewhere between 1.2 and 2.0. In case of Tensa International, the working capital ratio is 1.33. This indicates that its current liquidity position is good. However, a very high ratio, that is, above 2, indicates that the business has underutilized current assets, that is, it is not investing its assets properly.
On the other hand, negative working capital, that is, working capital ratio which is less than one, indicates that the business might not be in a position to meet its short term liabilities. It shows that the business will not be able to pay its creditors in time. A negative working ratio could also be due to reduced current assets. Negative working ratio should be analyzed very intently, as it might indicate that the sales of a company are going down and hence, accounts receivables are shrinking, thus causing a reduction in the current assets value.
Working Capital Management
- For maintaining an ideal ratio, working capital management is very necessary.
- Working capital management is a very important part of the financial management of a company.
- This is because the investors base their investment decisions on a number of ratios, such as working capital ratio, debt ratios, return on equity ratios, return on investment ratio, and return on assets ratio.
- For managing its working capital properly, a business should keep a few things in mind.
- Firstly, the credit period given to the customers should not be too long. This will ensure that the business has enough cash in hand from the realized sales.
- Secondly, to increase its liquidity position, the company itself should ask for longer credit period from its suppliers.
- Thirdly, the level of inventory maintained by a business should not be too high or too low. It should be sufficient enough to reduce the overall raw material costs.
- Fourthly, cash in hand and cash in bank should be managed, in such a way that cash holding costs for the business are reduced to a great extent.
- These measures will ensure that the cash conversion cycle of a company is not too long and thus, the company will have enough working capital in hand at any given time.
An appropriate working capital ratio is essential for the smooth functioning of a business. A negative ratio can hamper the future investments of a company, as the investors might feel that the business is not being run efficiently. Unavailability of enough liquid capital, which presents itself in the negative working capital ratio can sometimes, lead to bankruptcy too.