Working Capital RatioDefined along with Formula & How to Calculate

Written By:
Lisa Borga

A company’s working capital ratio, also known as the current ratio, is an essential ratio for a business to keep track of.

Without adequate working capital, an otherwise profitable business could easily go bankrupt.

Companies need sufficient working capital to meet current expenses.

It is also necessary in order to have the funding for new investments to help the business grow.

There are a number of metrics companies can use to help prevent these problems and the current ratio is one of them.

Working capital is found by subtracting a business’s current liabilities from its current assets.

The current ratio shows the ratio of a business’s current assets to its current liabilities.

These metrics are helpful in analyzing a business’s financial health.

How to Use the Working Capital Ratio

A business’s working capital ratio can show how efficient its operations are along with how healthy its short-term finances are.

This ratio can be computed by dividing a business’s current assets by its current liabilities.

Working Capital Ratio = Current Assets /  Current Liabilities

If a business has a working capital ratio that is high, it shows that the business’s current assets are greater than the business’s short-term debts.

Whereas if a business has a capital ratio that is low such as around one or less than one, it could show that the business may not have sufficient short-term assets to pay its short-term obligations.

Typically if a business is undertaking a major project, it will need working capital to invest. But, this will reduce the business’s cash flow.

A business’s cash flow will drop as well if sales decrease or if collections are slow.

One thing businesses that are not using their working capital efficiently tend to do to increase their cash flow is to pressure their customers or suppliers to pay.

An example of the working capital ratio would be if a business had current assets of $1,700,000 and current liabilities of $2,000,000.

This would mean the business has a capital ratio of .85.

Working Capital Ratio = Current Assets /  Current Liabilities

$1,700,000 / $2,000,000 = .85

Whereas, if the business had $1,700,000 in current liabilities and $1,700,000 in current assets, it would have a current ratio of one.

Working Capital Ratio = Current Assets /  Current Liabilities

$1,700,000 / $1,700,000 = 1

A Low Current Ratio

Businesses that have a working capital ratio of less than one have a negative cash flow.

This means it has more current liabilities than current assets.

Therefore, the business does not have sufficient working capital to pay its debts.

This indicates the business may have trouble paying off its creditors.

Should the business fail to increase its working capital or if its cash flow decreases further, it could face serious financial difficulties.

There are a number of reasons that could cause the business to have a decline in working capital, such as difficulties with accounts receivable, poorly managed inventory, or a decline in sales revenue.

A High Current Ratio

Although it is not good for a business to have a low working capital ratio, a high working capital ratio isn’t always good either.

It could mean that instead of reinvesting its capital in the company to help it grow, the business is just holding onto its cash.

Generally, a working capital ratio of 1.5 to 2.0 is considered ideal.

Businesses should compare their working capital ratio to other businesses in their industry as a good ratio can vary among industries.

Key Takeaways

• The working capital ratio of a business, as well as its working capital, are measurements that look at the business’s current assets and compare them to the business’s current liabilities.
• The current ratio can be computed by dividing a business’s current assets by its current liabilities. The working capital ratio can help the business assess its liquidity as well as its operational efficiency.
• If a business has a working capital ratio that is less than one, it may not have the ability to meet its short-term obligations. Whereas a business that has a very high working capital ratio may not be doing a good job of managing its excess cash flow. The excess cash flow might be more effectively used for the business’s growth.
• A current ratio of 1.5 to 2.0 is sometimes believed to be ideal, although an ideal working capital ratio can vary between industries.