The Working Capital Ratio and a Company's Capital Management

Businesses don't go bankrupt just because they're not profitable. Most business bankruptcies occur because the company's cash reserves ran dry, and they can't meet their current payment obligations. An otherwise profitable company may also run out of cash because of the increasing capital requirements of new investments as they grow.

There are several useful metrics that can help a company avoid these pitfalls. Working capital refers to the difference between a company's current assets and current liabilities. The working capital ratio compares these figures as a percentage. Both metrics can be useful in assessing the financial health of a company.

Using the Working Capital Ratio

The working capital ratio reflects a company's operational efficiency and the health of its short-term finances. The working capital ratio is calculated by dividing the company's current assets by its current liabilities:

$\begin{aligned}&\text{Working Capital Ratio} = \frac { \text{Current Assets } }{ \text{ Current Liabilities } } \\\end{aligned}$​Working Capital Ratio= Current Liabilities Current Assets ​​

A high working capital ratio means that the company's assets are keeping well ahead of its short-term debts. A low value for the working capital ratio, near one or lower, can indicate that the company might not have 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.

For example, if a company has $800,000 of current assets and has $1,000,000 of current liabilities, its working capital ratio is 0.80. If a company has $800,000 of current assets and has $800,000 of current liabilities, its working capital ratio is exactly 1.

Low Working Capital

If a company's working capital ratio falls below one, 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 low working capital, or if cash flow continues to decline, 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 1.5 and 2. As with other performance metrics, it is important to compare a company's ratio to those of similar companies within its industry.