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 a good 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 a bad working capital ratio? ›
A ratio below 1.0 is unfavorable, as it indicates the company's current assets are not sufficient to cover near-term obligations.
What is the optimum level of working capital? ›
The optimal level of working capital investment is the level expected to maximize shareholder wealth. It is a function of several factors, including the variability of sales and cash flows and the degree of operating and financial leverage employed by the firm.
What is an acceptable capital ratio? ›
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 the ideal amount of working capital? ›
A good working capital ratio (remember, there is no difference between current ratio and working capital ratio) is considered to be between 1.5 and 2, and suggests a company is on solid ground.
What is the ideal NWC ratio? ›
The optimal NWC ratio falls between 1.2 and 2, meaning you have between 1.2 times and twice as many current assets as you do short-term liabilities. If your NWC ratio climbs too high, you may not be leveraging your current assets with optimal efficiency.
What is reasonable working capital? ›
Reasonable Working Capital means an amount reasonably determined by Manager at the same time as the monthly financial statements are prepared pursuant to Section 15.02 hereof, but in no event to exceed a sum equal to a ratio of current assets to current liabilities of 2:1 (but excluding from such calculation cash ...
What is best capital ratio? ›
Also known as Best's Capital Adequacy Ratio, BCAR, examines an insurer's leverage, underwriting activities, and financial performance and uses this information to test various scenarios to see how each would impact the insurer's balance sheet.
A higher working capital ratio usually demonstrates a healthier financial position and a better capacity to repay short-term liabilities with short-term assets.
How to improve working capital ratio? ›
These working capital improvement techniques can help.
- Shorten Operating Cycles. An increased cash flow generates working capital. ...
- Avoid Financing Fixed Assets with Working Capital. ...
- Perform Credit Checks on New Customers. ...
- Utilize Trade Credit Insurance. ...
- Cut Unnecessary Expenses. ...
- Reduce Bad Debt. ...
- Find Additional Bank Finance.
Liquidity Management:Adequate working capital enables a company to meet its immediate financial obligations, including paying suppliers, salaries, and utility bills. This liquidity management is vital for business continuity.
What is the recommended 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.
How to interpret 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.
What are the 3 levels of working capital? ›
Variable working capital: Fluctuating capital to manage seasonal demands. Gross working capital: Total current assets available for daily operations. Net working capital: The difference between current assets and current liabilities.
Is it better to have a higher or lower working capital? ›
Broadly speaking, the higher a company's working capital is, the more efficiently it functions. High working capital signals that a company is shrewdly managed and also suggests that it harbors the potential for strong growth.
What is the ideal capital employed ratio? ›
The general rule about ROCE is the higher the ratio, the better. That's because it is a measure of profitability. A ROCE of at least 20% is usually a good sign that the company is in a good financial position.
How do you calculate ideal working capital? ›
Working capital = current assets – current liabilities. Net working capital = current assets (minus cash) - current liabilities (minus debt). Operating working capital = current assets – non-operating current assets. Non-cash working capital = (current assets – cash) – current liabilities.
What is a good 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.
