If you’re here, it’s because you are most likely curious about what the working capital ratio is and how it works. Also called the current ratio, the working capital ratio is a liquidity ratio, and it’s used to estimate a company’s ability to repay its current liabilities with current assets. Therefore, it’s important as it shows a firm’s liquidity.
Current assets such as cash equivalents, cash, and marketable securities are the best options when it comes to paying current liabilities. The reason is the fact that these assets are easier to convert into money faster compared to fixed assets. So, if assets can be converted into money faster, the firm will be more likely to have cash just in time to pay debts.
The next paragraphs will give you more information about this concept.
Analyzing Working Capital Ratio
Considering this equation estimates the current assets as a percentage of current liabilities, it should be no surprise that the higher ratio is preferred over the lower one. If the ratio is 1, it shows that the current assets equal current liabilities, and it’s considered middle ground. In other words, it’s not risky, but not fully safe either. So, the company would have to sell all the current assets to be able to repay its current liabilities.
If the ratio is less than 1, then it has risks. It indicates that the company doesn’t efficiently run, and it isn’t able to cover its current debt properly. A ratio like this is called negative working capital.
At the same time, if the ratio is more than 1, it indicates, as obvious, that the firm is able to repay all of its current liabilities while still having leftover current assets. It is called a positive working capital.
Considering the working capital ratio has two main moving assets, moving parts, and liabilities, it’s essential to know how they can work together. So, here are some examples of how certain changes can affect the ratio:
– Current liabilities decrease = increase in WCR
– Current liabilities increase = decrease in WCR
– Current assets decrease = decrease in WCR
How Is It Calculated?
Calculating the WCR is not that hard. You have to divide current assets by current liabilities. In other words, the formula looks like this:
You can find both of these current accounts stated separately from their long-term accounts on the balance sheet. This presentation is helpful to creditors and investors, as it allows them to get more data to analyze the firm. In financial statements, current assets and liabilities are always stated first, followed by long-term assets and liabilities.
Now, it should be easier for you to understand what the working capital ratio is and how it’s calculated. Keep in mind that a higher ratio is preferred over a lower one, as the positive one shows the company is able to pay off all of its current liabilities. Therefore, when you need to calculate it, take a look on the balance sheet. You will find the current accounts and liabilities there and be able to calculate the WCR.