A:

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 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. The working capital ratio reveals whether the company has enough short-term assets to pay off its short-term debt.

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.")

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