A company’s working capital is understood as the result from subtracting current assets from current liabilities. As a metric, the Working Capital Ratio is also known as the current ratio and it calculates a company’s capacity to cover for its current liabilities with its current assets. Simply put, it is a liquidity measure that unveils the short-term financial healthiness of a business.
What is the Working Capital Ratio?
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The Working Capital Ratio is employed by financial analysts, investors and lenders to determine a business’ capacity to cover for its short-term financial commitments. The ratio estimates how much of current liabilities, including accounts payable, customer deposits, short-term loans and accrued liabilities, are covered by current assets, which include cash, cash equivalents, inventory, accounts receivable and any other assets that can be converted in cash in less than a year.
A business that has a Working Capital Ratio lower than 1 will probably experience issues to cover its financial commitments within the short-term. On the other hand, a business that has a Working Capital Ratio of more than 1 has enough funds to cover for all its current liabilities.
For lenders, the current ratio is particularly important, as it serves as a key indicator of a company’s borrowing capacity. Companies with low Working Capital Ratios will probably get denied for new loans, as their payment capacity is in question. On the other hand, investors also look closely at the Working Capital Ratio to understand the company’s current financial health. A company with a low ratio has a higher chance of going bankrupt than one with a high ratio.
Working Capital Ratio Formula
The formula to calculate the Working Capital Ratio is the following:
Working Capital Ratio = Current Assets / Current Liabilities
Working Capital Ratio Equation Components
Current Assets: The sum of all assets that can be converted into cash in less than 1 year.
Current Liabilities: The sum of all liabilities that have to be paid in a period shorter than 1 year.
The result of the formula will be the number of times current assets cover for current liabilities and it can go from 0 to infinity (if current liabilities are equal to 0).
Working Capital Example
Marketing Systems LLC is a digital marketing agencies with offices in 5 countries within Europe. The business has over $7,000,000 in annual sales and it has more than 45 employees. They have a pretty conservative financial structure, as the business has been growing progressively by reinvesting earnings into building a great team of digital marketing professionals and securing a solid portfolio of clients.
The business recently has plans to continue expanding to 2 more countries and in order to do that they have to secure some long-term loans. The bank is currently reviewed their application, but everything indicates that they will be approved for it as they have solid financials. The company current assets and liabilities add up to:
Current Assets: $1,544,000
Current Liabilities: $468,000
With this information, both the business’ working capital and its Working Capital Ratio can be easily estimated:
Working Capital = $1,544,000 – $468,000 = $1,076,000
Working Capital Ratio = $1,544,000 / $468,000 = 3.30
These metrics indicate that the company will probably have no short-term financial challenges and therefore the bank is probably going to approve their loan application.
Working Capital Ratio Analysis
A company’s working capital is essential to sustain its regular operations throughout time. Working capital is not the same as cash flow, as cash flow metrics mainly deal with cash and cash equivalents to estimate a company’s capacity to fulfill short-term financial obligations.
In turn, Working Capital estimates focus more on the company’s portfolio of current assets. Some of these current assets, such as inventory and accounts receivable, can be converted into cash at a slower rate than cash equivalents. Which is the same case for pre-paid items such as insurance policies paid fully upfront.
In this sense, even though a company may suffer from low cash flow at a given point in time, its Working Capital may be in a good position. Nevertheless, the company’s ability to turn those assets into cash quickly will be a crucial element to make sure its financial obligations are paid for on time.
Some companies may need to operate with a higher Working Capital ratio than others, due to elements like seasonality and volatility. Companies that make most of their revenues during certain season of the year need to have a higher-than-average Working Capital ratio to cover for their expenses while the season is off. In turn, companies that are experiencing volatile sales, which means that there’s no predictable pattern as to how sales will look like next month, should also operate with a sufficient Working Capital ratio to make sure they can sustain temporary loses coming from underperforming sales.
Working Capital Ratio Uses, Cautions, Pitfalls
An important consideration to take into account when analyzing a company’s Working Capital is the short-term debt component. A company may seem financially healthy at one second and it could go broke in the next 6 months if a portion of its long term debt becomes a short term commitment and no refinancing is secured to cover for it. In order to avoid this, analysts incorporate a debt maturity schedule that allows them to identify upcoming due dates for a business’ long term debt that may radically change the Working Capital Ratio.
On the other hand, the Working Capital Ratio by itself does not assure that the business will have enough cash to cover for its obligations in the short-term, as the most illiquid current assets have to still be converted to cash to make that happen. A company suffering from a sales downturn may find it hard to transform inventories into cash, and even though the Working Capital ratio may seem healthy, if inventory is a major component of current assets and it can’t be converted quickly, the cash flow balance will eventually suffer. On the other hand, if a big portion of the receivables portfolio is associated to a client that is probably unable to comply with the due dates of its invoices, then the actual liquidity of the business will probably go into trouble.