What is considered a good working capital ratio?
The working capital ratio is a very basic measure of liquidity. It aims to indicate how well a company is able to meet its current financial obligations and is a measure of a company’s basic financial solvency. With reference to financial statements, it is the number that appears at the bottom of a company’s balance sheet.
Determine a good working capital ratio
The ratio is calculated by dividing current assets by current liabilities. It is also called current ratio.
Typically, a working capital ratio of less than one is considered an indication of potential future liquidity problems, while a ratio of 1.5 to two is interpreted as indicating a company on a solid financial footing in terms of liquidity.
A higher and higher ratio above two is not necessarily considered better. A significantly higher ratio can indicate that a business is not doing a good job of using its assets to generate the maximum amount of revenue possible. A disproportionate working capital ratio results in an unfavorable return on assets (ROA) ratio, one of the main profitability ratios used to evaluate companies.
What does the ratio of working capital to liquidity indicate?
Liquidity is of critical importance to any business. If a business cannot meet its financial obligations, it is in grave danger of bankruptcy, no matter how optimistic its prospects for future growth may be. However, the working capital ratio is not a truly accurate indication of a company’s liquidity position. It simply reflects the net result of the total liquidation of assets to satisfy liabilities, an event that rarely occurs in the business world. It does not reflect additional accessible financing a business may have, such as existing unused lines of credit.
Traditionally, businesses do not access lines of credit for more cash than needed, as this would incur unnecessary interest charges. However, operating on such a basis can make the working capital ratio appear abnormally low. Nonetheless, comparisons of working capital levels over time can at least serve as potential early warning indicators that a company may have problems in terms of timely collection of debts which, if not. not processed, could lead to a future liquidity crisis.
Measure liquidity through the cash conversion cycle
An alternative metric that can provide a more solid indication of a company’s financial solvency is the cash conversion cycle or the operating cycle. The cash conversion cycle provides important information about how quickly, on average, a business returns inventory and converts inventory into paid receivables.
Since low inventory turnover rates or low debt collection rates are often at the heart of cash or liquidity problems, the cash conversion cycle can provide a more accurate indication of potential liquidity problems than the ratio. working capital. The working capital ratio remains an important basic measure of the current relationship between assets and liabilities.