The working capital ratio is a measure of liquidity, revealing whether a business can pay its obligations. The ratio is the relative proportion of an entity's current assets to its current liabilities, and shows the ability of a business to pay for its current liabilities with its current assets. A working capital ratio of less than 1.0 is a strong indicator that there will be liquidity problems in the future, while a ratio in the vicinity of 2.0 is considered to represent good short-term liquidity.
To calculate the working capital ratio, divide all current assets by all current liabilities. The formula is:
Current assets ÷ Current liabilities = Working capital ratio
Working Capital Ratio Example
A potential acquirer is interested in the current financial health of the Beemer Designs retail chain, which sells add-on products for BMW automobiles. She obtains the following information about the company for the past three years:
|Year 1||Year 2||Year 3|
|Working capital ratio||2:1||1.7:1||1.3:1|
The rapid increase in the amount of current assets indicates that the retail chain has probably gone through a fast expansion over the past few years and added both receivables and inventory. The sudden jump in current liabilities in the last year is particularly disturbing, and is indicative of the company suddenly being unable to pay its accounts payable, which have correspondingly ballooned. The acquirer elects to greatly reduce her offer for the company, in light of the likely prospect of an additional cash infusion in order to pay off any overdue payables.
Problems with the Working Capital Ratio
The working capital ratio can be misleading if a company’s current assets are heavily weighted in favor of inventories, since this current asset can be difficult to liquidate in the short term. This problem is most obvious if there is a low inventory turnover ratio. A similar problem can arise if accounts receivable payment terms are quite lengthy (which may be indicative of unrecognized bad debts).
The working capital ratio will look abnormally low for those entities that are drawing down cash from a line of credit, since they will tend to keep cash balances at a minimum, and only replenish their cash when it is absolutely required to pay for liabilities. In these cases, a working capital ratio of 1:1 or less is common, even though the presence of the line of credit makes it very unlikely that there will be a problem with the payment of liabilities.