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 reference to financial statements, it is the figure that appears on the bottom line of a company's balance sheet.
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 on solid financial ground in terms of liquidity.
An increasingly higher ratio above two is not necessarily considered to be better. A substantially higher ratio can indicate that a company is not doing a good job of employing its assets to generate 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 serious 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 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, companies do not access credit lines for more cash on hand than necessary as doing 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.