Working capital ratio is a crucial financial metric used to understand a company’s financial well-being as well as liquidity position. It is a ratio of the company’s current assets and current liabilities. Analysing the working capital ratio of a company helps creditors and investors evaluate the business’s ability to fund day-to-day operations, make payroll, and ensure smooth functioning. It essentially sheds light on the operational efficiency of the business.
Companies with a low working capital ratio may have difficulties managing short-term payment obligations. They may have to opt for working capital financing to meet these urgent short-term payment needs. Understanding the meaning of working capital ratio can help companies with a low ratio implement various strategies to improve the same. Boosting the working capital ratio of a business is critical in ensuring better short-term liquidity management, conveying creditworthiness, and swaying investor confidence.
Understanding working capital ratio and its importance
Working capital ratio is a ratio of its current assets to its current liabilities. It is a metric that assesses the proportion of a business’s current assets relative to its liabilities. In simple words, the working capital ratio of a company indicates if the business has enough existing assets to meet its current liabilities. Current assets are those assets which can be converted into cash within the next 1 year. Typically, assets like cash and cash equivalents, accounts receivable, inventory, and short-term investments are classified as current assets. Current liabilities, on the other hand, include due payment obligations with a deadline of 1 year or less. This includes liabilities like short-term debts, accounts payable, payroll payments, and taxes.
Working capital ratio is an essential financial metric because it provides an overview of the business’s financial health and liquidity. It offers valuable insights to creditors and investors about the company’s ability to repay short-term debt, operational efficiency, and ability to generate cash flow.
How to calculate working capital ratio?
The working capital ratio of a business is calculated by dividing the business’s current assets by its current liabilities. The following formula is used to compute the working capital ratio of a company:
Working Capital Ratio = Current Assets / Current Liabilities |
Let’s assume that the current asset ledger of a business stands at Rs. 3,00,000. The current liabilities ledger for the same business stands at Rs. 2,50,000. In this case, the working capital ratio for the business will be:
Working Capital Ratio = 3,00,000/2,50,000
Working Capital Ratio = 1.2
Interpreting different working capital ratios
To understand working capital ratio and its significance, you must understand how to interpret these ratios. Interpreting working capital ratios is fairly simple. Here’s a quick run-down to sum-up working capital ratio interpretations:
- When the working capital ratio of a business is more than 1, it is considered as a positive sign for creditors and investors. A ratio that’s higher than 1 suggests that the business can theoretically pay off current liabilities with all of its current assets.
- When the working capital ratio of a business is below 1, it can indicate future liquidity concerns. In simple words, companies with ratios below 1 may not be able to pay creditors, meet operational costs, and fulfil short-term obligations with current assets.
- When the working capital ratio is above 2, it can indicate that the company is not utilising its assets to foster growth.
A good working capital ratio lies between 1.5 and 2. Slipping below 1.5 would mean the business is struggling to meet its short-term obligations. Working capital ratios below 1 indicate that the business is working with a negative net working capital. Ratios above 2 are also unfavourable as they suggest cash hoarding and stagnated growth investments. However, the ideal working capital ratio can vary depending on various parameters like the sector the business operates in, how established it is, and whether or not it’s in the growth phase.
However, it is important to note that the working capital ratio of a company can be influenced by various temporary factors and can be misleading, if not contextualised correctly. For example, businesses in the growth stage that are leveraging external credit to grow and expand may have a low working capital ratio. However, once the growth pays off, their working capital ratios will likely improve. Another example would be businesses with a very high inventory turnover rate. Due to their short cash conversion cycles, such businesses can afford to maintain what would otherwise be deemed as a poor working capital ratio.
Easy ways to improve your working capital ratio
The working capital ratio of a business can be improved by improving its working capital position. This can be done in one of the two following ways:
- Increase/speed up the cash inflow into the business.
- Decrease/slow down the cash outflow from the business.
Based on these core objectives, you can implement the following strategies to improve your working capital ratio:
Boost efficiency of the accounts receivables process
Try expediting the collection of accounts receivable from customers. A shorter collection cycle can help ensure an improved cash inflow. You can try deploying solutions like early payment programs to promote early payments.
Efficiently manage inventory
Sometimes high inventory levels can bloat your working capital ratio. Surplus stock essentially means that there is working capital tied up in inventory. Ordering stock only when it is needed helps prevent inventory surplus. You can rely on inventory management software to streamline this process.
Negotiate longer payment terms with your supplier
Improving your communication with suppliers can have several benefits, including a better working capital ratio. Negotiating for better payment terms with suppliers can help. By negotiating longer payment tenures, securing discounts on early payments, using supply chain financing, you can optimise the accounts payable side as well.
Eliminate expenses
Another key strategy to improve short-term liquidity and working capital ratios is cutting unnecessary expenses. Start by reviewing your operational budget and try to identify cost-saving avenues. Wherever there is superfluous spending, try eliminating it.
Avoid utilising working capital for fixed asset financing
Instead of leveraging working capital financing to purchase fixed assets like equipment and machinery, try availing a long-term business loan. Long-term business loans have a longer repayment tenure than working capital financing, meaning a more favourable impact on reducing your current liabilities.
Conclusion
Maintaining a balanced working capital ratio is crucial for a company’s financial health and operational efficiency. The working capital ratio of a company is an essential metric that reflects on its liquidity position as well as its ability to manage short-term obligations. Ideally, a good working capital ratio lies between 1.5 and 2. However, this can vary depending on the growth stage of the company. Optimising accounts receivable collections, streamlining inventory management, cutting unnecessary expenses, and negotiating better payment terms with suppliers can help boost the working capital ratio of a company. You can also opt for working capital financing to access immediate liquidity to cover short-term obligations and stabilise operations. Implementing these strategies can ensure competitive advantage and drive sustainable growth.
Frequently Asked Questions
What is considered a good working capital ratio?
A ‘good’ working capital ratio is not a one-size-fit-all number. It can vary depending on factors like industry segment, growth stage of the business, and business model. That said, most experts suggest a working capital ratio between 1.5 and 2 as the ideal number.
What are the limitations of using a working capital ratio?
While working capital ratio is an essential metric, it does not offer a comprehensive view of the financial well-being of the business. It does not take into account the timing of cash inflows and outflows which can have a significant impact on a business’s ability to meet short-term obligations.
What is the disadvantage of a very high working capital ratio?
A very high working capital ratio that’s above 2 can signal improper asset management. Having idle or surplus inventory, receivables, or cash means that the company could use these assets more productively elsewhere. Failing to optimise the use of current assets may mean missing out on higher returns.