What is the working capital ratio?
The working capital ratio, also known as the current ratio, is a financial metric that measures a company’s ability to cover its short-term liabilities with its short-term assets. A higher ratio indicates that the company has more than enough assets to cover its liabilities, while a lower ratio may indicate liquidity issues. The working capital ratio is essential for businesses as it helps assess their financial health, particularly their ability to meet immediate financial obligations. A working capital ratio between 1.2 and 2.0 is generally considered healthy. This ratio is crucial in determining whether a company has sufficient working capital to maintain operations without the need for external financing. Regularly monitoring this ratio allows businesses to ensure they have enough liquidity to meet their day-to-day operational expenses.
Working capital ratio formula
The working capital ratio is calculated using a simple formula:
Working capital ratio = Current assets / Current liabilities.
This formula provides a quick snapshot of a company’s liquidity. 'Assets' represent the resources a company owns and can quickly convert into cash, such as inventory, cash in hand, and accounts receivable. 'Liabilities' refer to the company's debts or financial obligations, including accounts payable, short-term debt, and other current liabilities. A ratio of less than 1 indicates that a company’s liabilities exceed its assets, which may lead to liquidity issues. A ratio of over 2 could mean the company is not efficiently utilising its assets to generate revenue.
How to calculate working capital ratio?
The working capital ratio is calculated by dividing a business's current assets by its current liabilities. The formula is:
Working capital ratio = Current assets/Current liabilities
For example, if a business in India has ₹10,00,000 in current assets and ₹5,00,000 in current liabilities, the working capital ratio would be calculated as:
10,00,000 / 5,00,000 = 2
The working capital ratio is sometimes referred to as the current ratio. This is because it takes into account current assets and liabilities, which are typically expected to be converted into cash within a year.
Indian businesses often calculate the working capital ratio regularly, as it provides a clear picture of their financial health and helps track any changes in their working capital position over time.
Working capital ratio examples
A company with ₹15,00,000 in assets and ₹7,50,000 in liabilities has a working capital ratio of 2, which indicates a healthy liquidity position. On the other hand, a company with ₹8,00,000 in assets and ₹10,00,000 in liabilities would have a working capital ratio of 0.8. This would suggest potential financial challenges, as the company does not have enough assets to cover its liabilities. A ratio below 1 often signals a company is struggling to meet its short-term obligations.
Why does the working capital ratio matter?
- Liquidity assessment: It helps businesses understand their short-term financial health.
- Operational stability: A good ratio ensures the company can meet operational expenses without financial strain.
- Investor confidence: Investors and lenders use the working capital ratio to assess the company's financial stability.
- Decision making: Helps management decide whether they need to improve asset utilisation or seek additional funding.
- Early warning sign: A low ratio indicates potential liquidity issues, helping management take corrective actions in time.
What does the working capital ratio reveal about liquidity?
The working capital ratio is a key indicator of a company's liquidity, offering insight into its ability to meet short-term obligations. A high ratio indicates that the business is in a strong liquidity position, with enough assets to cover liabilities. A low ratio suggests liquidity issues, potentially signalling that the company may face difficulties meeting financial obligations without external assistance. Monitoring this ratio allows businesses to take pre-emptive actions if liquidity concerns arise, ensuring smooth operational flow and financial stability.
What is a good working capital ratio?
A good working capital ratio typically falls between 1.2 and 2.0. A ratio in this range suggests that the business has a sound balance between maintaining liquidity and effectively utilising its resources. If the ratio is too high, the company may be hoarding assets that could be better invested elsewhere. Conversely, if the ratio is too low, it suggests the company might struggle to meet its short-term obligations, which could lead to operational challenges or the need for external financing. It’s important to evaluate industry standards as well, as optimal ratios can vary across sectors.
How to improve working capital ratio?
- Reduce liabilities: Pay off short-term debts and negotiate better payment terms with creditors.
- Increase assets: Focus on increasing accounts receivables by offering better credit terms to customers.
- Inventory management: Optimise inventory levels to free up cash while ensuring enough stock to meet demand.
- Expense control: Keep operating expenses in check to avoid unnecessary liabilities.
- Short-term loans: Consider securing a short-term business loan to temporarily boost liquidity.
Interpreting a negative working capital ratio
A negative working capital ratio occurs when a company's current liabilities exceed its current assets, signalling potential financial distress. This situation, known as negative working capital, suggests that the business does not have enough liquid assets to meet its short-term liabilities, which could lead to cash flow issues. Companies in this situation often rely on short-term borrowing or may need to sell off assets to cover their debts. A sustained negative working capital ratio is a red flag for both investors and lenders, as it indicates possible solvency issues and a lack of liquidity, making the business vulnerable to financial instability.
Conclusion
In conclusion, the working capital ratio is a vital measure of a company’s short-term financial health. Businesses with a healthy ratio can meet their day-to-day obligations and are more likely to secure favourable terms on a business loan from Bajaj Finance. By managing assets efficiently, controlling liabilities, and continuously monitoring liquidity, businesses can maintain an optimal working capital ratio, which is crucial for sustainable growth.
