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 the ideal 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 an acceptable capital ratio? ›
Understanding CAR. 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 a bad working capital ratio? ›
A ratio greater than 3 suggests a company may not be using its assets effectively to generate future growth. Your money should be working for you as hard as your employees are. For example, developing new products and services, looking for new markets, planning ahead to remain competitive.
What is ideal capital ratio? ›
Highlights of Capital Adequacy Ratio (CAR)
CAR ensures that a layer of safety is present for the bank to manage its own risk weighted assets before it can manage its depositors' assets. Indian public sector banks must maintain a CAR of 12% while Indian scheduled commercial banks are required to maintain a CAR of 9%.
What is the optimal level of working capital? ›
OPTIMUM WORKING CAPITAL:
Traditionally, Current Ratio (Current Assets: Current Liabilities) of 1.5 to 3 is considered to be comfortable liquidity position. However, it should be remembered that optimum working capital can be determine only with the reference to a particular circ*mstances.
What is the rule of thumb for working capital? ›
Although many factors may affect the size of your working capital line of credit, a rule of thumb is that it shouldn't exceed 10% of your company's revenues.
How much working capital is ideal? ›
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.
Is 4 a good working 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.
A ratio between 1.5 and 2 is generally seen as just right — it means you've got a healthy balance. You're able to pay off debts while still having enough to grow. A high working capital ratio can be a mixed bag, suggesting you might be sitting on too much inventory or not investing enough in growth.
What is best capital ratio? ›
Best's Capital Adequacy Ratio (BCAR) is an integrated review of a life, non-life or composite insurer's underwriting, financial performance and asset leverage.
What is a good ratio for capital employed? ›
What Is a Good Percentage for Return on Capital Employed? 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.
What is a favorable working capital ratio? ›
Determining a Good 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.
What is a good current ratio working capital? ›
For many small businesses, a working capital ratio between 1.5 and 2 is ideal. Again, you don't want your working capital to be too low, as you may be unable to meet your short-term obligations in that case.
What is a too high working capital turnover ratio? ›
However, a ratio higher than 2.0 may be interpreted negatively. An excessively high ratio suggests the company is letting excess cash and other assets just sit idle, rather than actively investing its available capital in expanding business. This indicates poor financial management and lost business opportunities.
What is the ideal capital employed ratio? ›
What Is a Good Percentage for Return on Capital Employed? 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.
Is it better to have high or low working capital? ›
But a deficit of working capital could signal a potential bankruptcy. Usually, the greater a company's capital is, the better. It means their liquid assets (those that can be turned into cash within a year) outweigh their liabilities, such as payroll, debts, taxes, or other liabilities (due in the next 12 months).
How much is too much working capital? ›
1.0 to 2.0: Short-term liquidity is optimal. The company is on firm financial footing and has positive working capital. 2.0 and above: While high working capital is definitely preferable to low in most cases, a current ratio that's too high can actually be a sign of underutilized capital.
