A firm’s working capital ratio is an indicator of short-term financial health. This indicator helps a small business owner, investor, and any financial analysis team to understand whether the firm is in a good position to pay current dues and run daily operations or not. It is very important to do a working capital ratio to set goals and target future growth.
Let’s discuss the following;
- What is the working capital ratio?
- Working capital ratio’s importance.
- How to calculate it?
- Interpreting working capital ratios.
- How to enhance the working capital ratio?
What is the Working Capital Ratio?
The working capital ratio indicates and shows the strength of a company in terms of its ability to pay and clear short-term liabilities by balancing short-term assets in the form of cash, inventory, accounts receivable, and so on.
It expresses the ratio of current assets to current liabilities in numerical form. Often, it can be enlightening to compare the components that go into the working capital ratio- cash, inventory, and receivables versus accounts payable and short-term loans-to ascertain whether there really is a financial difficulty in meeting the business’s short-term obligation.
For example, a working capital ratio is 2:1. That would mean that the company has two rupees in assets to cover every rupee of liability.
Why this ratio is important has been discussed below:
Liquidity Check: This will reveal how easily the company can pay off short-term debt. Even a profitable firm will face operating trouble without liquidity.
Operational Efficiency: A proper working capital ratio means that it is using the assets and liabilities efficiently. It is an indication of good financial discipline because growth in business cannot be sustained without this.
Investment Decisions: The ratio assists the investors as well as the financial analysts to understand how risky the debts of a specific company are. In the event the ratio is low, then it may imply that the firm might not be in a position to meet the commitments based on the debts, which would present a very significant risk.
Creditworthiness: Banks and financial institutions often consider the working capital ratio to determine whether or not to extend credit to a business. A good ratio indicates that the business is sound and capable of sustaining further loans or credit. If a business plans for a secured or unsecured business loan to expand they would need an ideal ratio of working capital.
How to Calculate Working Capital Ratio:
The working capital ratio is quite easily calculated. The formula is:
Working Capital Ratio = Current Assets / Current Liabilities
Current Assets = cash + accounts receivable + inventory + others that are liquid assets or can be converted into cash in 1 year.
Current Liabilities = accounts payable + short-term loans + any other debt obligations due in 1 year.
Take the following example:
If a company has ₹5,00,000 in current assets and ₹2,50,000 in current liabilities, the working capital ratio would be:
Working Capital Ratio = ₹ 5,00,000 / ₹ 2,50,000 = 2
This shows that it is healthy where the company keeps twice the current assets than liabilities.
Interpretation of Working Capital Ratios
The result of the working capital ratio can give us valuable insights as follows;
High Ratio (Above 2): It indicates that the company has more than adequate assets to cover the liabilities. Hence it might be looked upon as a positive thing, but a highly elevated ratio might also imply that the firm is not utilizing its assets efficiently. It might just have too much cash or inventory lying idle, which could otherwise be invested for growth.
Optimal Ratio (Between 1.5 and 2): Ideally, most of them are in this range. The company maintains the best balance between liquidating its assets for immediate usage and keeping them for future usage. The business will be in a stable position to meet its short-term obligations as well as use some of its resources for expansion.
Low Ratio (Below 1): This means that statistically speaking, the company lacks sufficient assets to pay off its liabilities, thus indicating some form of liquidity problem. The company may not be able to meet its payments and in worse instances be placed financially in a bad position due to lack of payment.
How to Enhance Working Capital Ratio
When an enterprise feels that its working capital ratio is too low, one of the options that can be used to improve it is suggested as follows:
Improve Inventory Management: Too much inventory holds up a company’s resources. Optimizing the level of inventory for free cash can also help improve the ratio.
Speed up Accounts Receivable: A company can try to collect payments from its customers faster. One option is to offer discounted early payment or tighten credit terms.
Negotiate longer payment terms: Businesses can negotiate payment terms with suppliers. This would reduce current liabilities and improve the working capital ratio.
Payables: Pay off short-term loans or convert them into long-term debt. This will reduce current liabilities, thereby improving the working capital ratio.
Keep tight control over operating expenses: If operating expenses do not pile up, liabilities will not accumulate either. Efficient cost management improves the ability of the company to meet its obligations without relying too heavily on current assets.
Conclusion
A company can track “liquidity, operating efficiency, creditworthiness, and investment risks” through the calculation of the working capital ratio. In this way, having an optimal working capital ratio would ensure that the business could be in good shape to pay liabilities and sustain itself while it grows. The working capital ratio can improve if a company manages inventory, accelerates receivables, stretches payment terms, and exercises sharp control over operating costs.
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