Businesses that go bankrupt don't usually do so because they're not profitable. Rather, they go bankrupt because their cash reserves run dry, and they can't meet current payment obligations. An otherwise profitable company may also run out of cash because their capital requirements continue to increase in order to support additional investment in inventories and accounts receivable as they grow. The working capital ratio can help you avoid this pitfall.
The working capital ratio is commonly used to assess a company's financial performance. Low working capital ratio values, near one or lower, can indicate serious financial problems with a company. The working capital ratio reveals whether the company has enough short-term assets to pay off its short-term debt.
Most major projects require an investment of working capital, which reduces cash flow. Cash flow will also be reduced if money is collected too slowly, or if sales volumes are decreasing, which will lead to a fall in accounts receivable. Companies that are using working capital inefficiently often try to boost cash flow by squeezing suppliers and customers.
The working capital ratio measures a company's efficiency and the health of its short-term finances. The formula to determine working capital is the company's current assets minus its current liabilities.
Working Capital=Current Assets−Current Liabilities
For example, if a company has $800,000 of current assets and has $400,000 of current liabilities, its working capital is $400,000. If a company has $800,000 of current assets and has $800,000 of current liabilities, it has no working capital.
Changes in Assets and Liabilities Affect Working Capital
Changes to either assets or liabilities will cause a change in net working capital unless they are equal.
For example, If a business owner invests an additional $10,000 in her company, its assets increase by $10,000, but current liabilities do not increase. Thus, working capital increases by $10,000. If that same company were to borrow $10,000, and agree to pay it back in less than one year, the working capital has not increased because both assets and liabilities increased by $10,000.
Low Working Capital
If a company's working capital ratio value is below zero, it has a negative cash flow, meaning its current assets are less than its liabilities. The company cannot cover its debts with its current working capital. In this situation, a company is likely to have difficulty paying back its creditors. If a company continues to have a low working capital, or if it continues to decline over a period of time, it may have serious financial trouble. The cause of the decrease in working capital could be a result of several different factors, including decreasing sales revenues, mismanagement of inventory, or problems with accounts receivable.
High Working Capital
An excessively high working capital is not necessarily a good thing either, since it can indicate the company is allowing excess cash flow to sit idle rather than effectively reinvesting it in company growth. Most analysts consider the ideal working capital ratio to be between 1.2 and 2. As with other performance metrics, it is important to compare a company's ratio to those of similar companies within its industry.
(For related reading, see "Working Capital Position.")