Working capital ratio
/What is the Working Capital Ratio?
The working capital ratio is a measure of liquidity, revealing whether a business can pay its obligations. The ratio is the relative proportion of an entity's current assets to its current liabilities, and shows the ability of a business to pay for its current liabilities with its current assets. A working capital ratio of less than 1.0 is a strong indicator that there will be liquidity problems in the future, while a ratio in the vicinity of 2.0 is considered to represent good short-term liquidity. The ratio is used by lenders and creditors when deciding whether to extend credit to a borrower.
What is Working Capital?
Working capital is the funds a business needs to support its short-term operating activities. “Short-term” is considered to be any assets that are to be liquidated within one year, or liabilities to be settled within one year. The short-term nature of working capital differentiates it from longer-term investments in fixed assets. Working capital is defined as the difference between the reported totals for current assets and current liabilities, which are stated in an organization’s balance sheet. Current assets include cash, short-term investments, trade receivables, and inventory. Current liabilities include trade payables, accrued liabilities, taxes payable, and the current portion of long-term debt.
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How to Calculate the Working Capital Ratio
To calculate the working capital ratio, divide all current assets by all current liabilities. The formula is as follows:
Current assets ÷ Current liabilities = Working capital ratio
Interpreting the Working Capital Ratio
As just noted, a working capital ratio of less than 1.0 is an indicator of liquidity problems, while a ratio higher than 2.0 indicates good liquidity. A low ratio can be triggered by difficult competitive conditions, poor management, or excessive bad debts. In addition, an unusually high ratio can merely mean that a business is retaining too many current assets, which might be better deployed in research & development activities or adding production capacity. Excess assets might also be sent back to shareholders in the form of dividends or stock buybacks.
Another possible reason for a poor ratio result is when a business is self-funding a major capital investment. In this case, it has drawn down its cash reserves in anticipation of making more money in the future from its investment. If so, the ratio should improve in later reporting periods.
A low ratio may be acceptable if a business has a large unused line of credit. If so, it can avert any short-term credit problems by accessing the line of credit. However, the low ratio will still be a concern over the long term, when the line of credit is eventually tapped out.
Example of the Working Capital Ratio
A potential acquirer is interested in the current financial health of the Beemer Designs retail chain, which sells add-on products for BMW automobiles. She obtains the following information about the company for the past three years:
| Year 1 | Year 2 | Year 3 | |
| Current assets | $4,000,000 | $8,200,000 | $11,700,000 |
| Current liabilities | $2,000,000 | $4,825,000 | $9,000,000 |
| Working capital ratio | 2:1 | 1.7:1 | 1.3:1 |
The rapid increase in the amount of current assets indicates that the retail chain has probably gone through a fast expansion over the past few years and added both receivables and inventory. The sudden jump in current liabilities in the last year is particularly disturbing, and is indicative of the company suddenly being unable to pay its accounts payable, which have correspondingly ballooned. The acquirer elects to greatly reduce her offer for the company, in light of the likely prospect of an additional cash infusion in order to pay off any overdue payables.
Problems with the Working Capital Ratio
The working capital ratio can be misleading if a company’s current assets are heavily weighted in favor of inventories, since this current asset can be difficult to liquidate in the short term. This problem is most obvious if there is a low inventory turnover ratio. A similar problem can arise if accounts receivable payment terms are quite lengthy (which may be indicative of unrecognized bad debts).
The working capital ratio will look abnormally low for those entities that are drawing down cash from a line of credit, since they will tend to keep cash balances at a minimum, and only replenish their cash when it is absolutely required to pay for liabilities. In these cases, a working capital ratio of 1:1 or less is common, even though the presence of the line of credit makes it very unlikely that there will be a problem with the payment of liabilities.