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A company’s working capital ratio indicates how capable it is of meeting its current payment obligations. It compares a firm’s current assets to its current liabilities and is expressed as a ratio.The working capital ratio is a key metric of a company’s financial health because it tells you whether or not the business is solvent. No matter how profitable a company is, it will go out of business if its cash reserves run dry and it can’t pay its bills. Here’s a closer look at the working capital ratio, from how to calculate it to how it works to what it can tell you about your business.
What Is the Working Capital Ratio?
The working capital ratio is a measure of a firm’s liquidity. It reveals whether a business can pay its current liabilities with its current assets by dividing the former by the latter. Current assets are assets that can be converted into cash within the next 12 months. They include accounts receivable, equipment, inventory, and cash. Current liabilities are liabilities that need to be paid within the next year. They include trade payables, accrued liabilities, taxes payable, an operating line of credit from a bank, and the portion of long-term debt expected to be repaid within the next 12 months.If you have a low ratio, this may indicate that your company may not have enough assets on hand to cover your current debt. If you have a high ratio, on the other hand, you have more assets than liabilities, and if you needed to, could easily pay off your current debts.Working capital ratio is shown at the bottom line of a company's balance sheet.
What Is Working Capital?
Working capital is funds a business needs to support its short-term operating activities. It represents the difference between a company’s current assets and current liabilities and is calculated with this formula:Current Assets - Current Liabilities = Working CapitalIf a company has substantial positive working capital, then it is in a better position to invest in expansion and grow the company. If a company’s current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors. It could potentially even go bankrupt.
Working Capital Ratio Formula
The working capital ratio is calculated simply by dividing total current assets by total current liabilities. Here is the formula:Current Assets ÷ Current Liabilities = Working Capital Ratio
How Does the Working Capital Ratio Work?
Using the formula above, the working capital ratio is easy to calculate and both numbers used in the formula are found on a company's balance sheet.A high working capital ratio means that the company’s assets are staying well ahead of its short-term debts. With a high working capital ratio, a company has the flexibility to expand operations.A low value for the working capital ratio, on the other hand, can indicate that the company might not have enough short-term assets to pay off its short-term debt. If your firm’s working capital ratio is decreasing, you’ll want to understand why. The ideal ratio depends on your industry and specific situation. Generally speaking, If it is less than 1:1, it can indicate that you are finding it hard to pay bills. Even when the ratio is higher than 1:1, you may have difficulty, depending on how quickly you can sell inventories and collect accounts receivable. A ratio of 2:1 can offer a reasonable level of comfort.
What the Working Capital Ratio Is Used for
The working capital ratio is used to determine a company's operational efficiency and the health of its short-term finances. Business owners will look at this ratio to determine the liquidity of their company and whether they have capital available to invest in new projects. When a company applies for a small business loan, the lender may look at its working capital ratio, since it can indicate how likely that firm will be to repay the debt.
Low vs High Working Capital Ratio & What They Indicate
There is a sweet spot with the working capital ratio – you generally don’t want it to be too low, nor do you want it to be too high. Here’s why.
Low Working Capital Ratio
Generally, a working capital ratio of less than 1 can cause some concern about your company’s financial wellbeing. This ratio means that your company has a negative cash flow or, in other words, its current liabilities exceed its current assets. This can be caused by decreasing sales revenues, mismanagement of inventory, or problems with accounts receivable.A company with a low working capital ratio may have trouble paying backs its creditors. If the company continues to have a low working capital ratio, it could face serious financial trouble and possibly even bankruptcy.
High Working Capital Ratio
A high working capital ratio (1.5 to 2) generally indicates that a company is on solid financial ground in terms of liquidity. It means that the company's assets are keeping well ahead of its short-term debts. Higher than that, however, is not necessarily better. An excessively high working capital can indicate the company is allowing excess cash flow to sit idle rather than effectively reinvesting it in company growth. A very high working capital ratio can lead to an unfavorable return on assets ratio (ROA), which is another key profitability ratio used to evaluate companies.
Working Capital and Liquidity
Working capital (the difference between a company’s short-term assets and its short-term liabilities) is a measure of a firm’s liquidity, or how quickly it can convert its assets to cash. It represents a firm’s ability to generate cash to pay for its short-term financial obligations. A company that has positive working capital likely has enough liquidity to pay its bills in the coming months. It if has negative working capital, it may not have enough liquidity to cover its debts.Positive working capital and liquidity can help a company obtain small business loans with attractive rates and terms or establish a working capital credit line with a bank. Negative working capital, on the other hand, can make it harder to qualify for loans, since it indicates your firm doesn’t have enough liquidity to cover its debts.With positive working capital, suppliers and vendors may also allow you to pay them back via trade credit, meaning you won’t have to pay for 30, 60, or 90 days.You may be able to increase liquidity (and working capital) by getting customers to pay you faster, delaying the payment of your liabilities, or taking out a loan. You might decrease liquidity if you purchase large amounts of inventory or pay your debts too soon before you have the capital to cover expenses.
Working Capital Ratio vs Net Working Capital Ratio
The term “net working capital ratio” is used interchangeably with “working capital ratio,” just as “net working capital” is used interchangeably with “working capital.” These terms mean the same thing. Net working capital ratio, just like working capital ratio, measures a business’s ability to pay off its current liabilities with its current assets.The formula is the same:Current Assets ÷ Current Liabilities = Net Working Capital RatioAnother term commonly used for working capital ratio is “the current ratio.”
Pros and Cons of Using the Working Capital Ratio
Like many other financial metrics, the working capital ratio can offer useful insight into a firm’s financial health. At the same time, it has some limitations.
Pros of Using the Working Capital Ratio
Cons of Using the Working Capital Ratio
Measures the liquidity of the company
Working capital is always changing, so it may not represent a firm’s current position
Necessary to ensure uninterrupted operations
Doesn’t distinguish between types of current assets (some, like accounts payable, are less dependable than others)
Indicates how capable a company is of meeting its current financial obligations
Current assets can quickly become devalued
Shows the management’s efficiency in meeting creditors’ demands
Relies on correct accounting practices and assumes all debts are known
Working Capital Ratio Example
Here’s an example to illustrate how you can calculate your working capital ratio. Let’s say your business has $1 million in current assets, including accounts receivable, equipment, and cash. It also has $700,000 in liabilities, including short-term debts and expenses. Here’s how you would calculate your working capital ratio:1 million ÷ 700,000 = 1.43Your working capital ratio would be 1.43. This means you have enough liquidity to cover your short-term liabilities.
The Takeaway
The working capital ratio measures a business’s ability to pay off its current liabilities with its current assets. It’s different from working capital, which refers to the difference between current assets and current liabilities. Working capital ratio involves division, whereas working capital requires subtraction. Calculating your firm’s working capital ratio can give you an idea of your business’s liquidity and help you determine its overall financial health. It can also give you a sense of how likely you are to qualify for different types of small business loans.To learn the most from your working capital ratio, it can be a good idea to compare ratios across different time periods of data and track changes in working capital to see if your firm’s net working capital ratio is rising or falling. It can also be helpful to compare your ratios to those of other businesses in the same industry.
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Frequently Asked Questions
What is the working capital ratio formula?
What is considered a good working capital ratio?
What is the difference between working capital ratio and current ratio?
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About the Author
Susan Guillory
Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.
