Home Blog What Is A Good Working Capital Ratio (All You Need To Know)

What Is A Good Working Capital Ratio (All You Need To Know)

What Is A Good Working Capital Ratio?

What is a healthy working capital ratio for companies?

How does it work?

Keep reading as I have gathered exactly the information that you need!

Let me explain to you what is an optimal working capital ratio to aim for!

Are you ready?

Let’s get started!

What Is A Good Working Capital Ratio

Working capital ratio provides you with a measure of how well the company is able to meet its current obligations using its current assets.

You can calculate the working capital ratio by using the following formula:

Working Capital Ratio = Current Assets / Current Liabilities 
Author

To calculate the working capital ratio, you can get the current asset and current liability numbers from a company’s balance sheet.

High Working Capital Ratio

A high working capital ratio indicates that the company is probably not using its assets to grow the business as there’s a lot of liquidity that is not being utilized.

In other words, the company has a lot of current assets and can easily cover its current liabilities.

For example, if a company has $5,000,000 in current assets and $500,000 in current liabilities, its working capital ratio will be 10. 

This may suggest that the company may not be utilitizing its short-term assets to invest in the business or generate returns.

In essence, the company is letting cash sit idle without producing any returns for the company.

Low Working Capital Ratio

A low wording capital ratio suggests that the company does not have enough liquidity and short-term assets to pay for its short-term assets.

When the working capital ratio falls below 1.0, it means that the company does not have enough short-term assets to pay for its short-term debt.

For example, if the company has $1,000,000 in short term assets and $1,500,000 in short term debt, it will have a working capital ratio of 0.67.

If the situation persists long enough, the company may eventually use up all its cash reserves and no longer be able to operate its business.

Here are some reasons why a company’s working capital ratio may drop:

  • The launch of a new product
  • The start of a new project
  • Slow accounts receivable collection
  • Decreasing sales 

Good Working Capital Ratio

So what is a good working capital ratio for a company?

Although there’s no cookie-cutter answer to this question, many experts believe that a working capital ratio of 1.5 to 2.0 is a good working capital ratio to aim for.

This means that for every dollar of short-term debt, the company should have at least $1.5 to $2.0 of short-term assets to be able to assume its financial obligations.

However, a company having a very low or very high working capital does not mean that it is either at risk or not using its capital well.

For example, a company may be saving up capital to make an important equipment acquisition using more equity than debt. 

Alternatively, a company’s working capital may have dropped significantly as it has launched a new product that will generate significant returns to the company.

The working capital ratio of 1.5 to 2 is a good rule of thumb but every business’s optimal working capital ratio may be slightly different.

Measure of Liquidity

Having a good working capital ratio (WCR) suggests that a company has good operating liquidity to cover its financial obligations.

However, this measure is not a perfectly accurate measure of liquidity.

The WCR calculates the hypothetical situation that if the company was fully liquidated, how much of its short-term liabilities can it pay off using its short-term assets.

This hypothetical situation is not realistic and seldom happens in real life.

The fact is that companies may choose to carry a lower level of working capital as they have access to a cheap source of capital through a line of credit.

Also, normal business operations and capital expenditures may result in varying levels of working capital where it would not be accurate to draw the conclusion that the company has liquidity issues.

When calculating the company’s working capital ratio, it must be considered along with other liquidity factors and financial ratios to paint a more accurate picture of the company’s liquidity.

What Is An Example of A Good Working Capital

Let’s look at an example of what is considered a good working capital.

Imagine that a company has $5,000,000 in current assets and $2,500,000 in current liabilities.

The company’s working capital ratio is 2.0 or 2:1.

This is considered a good WCR.

On the other hand, imagine that another company has $5,000,000 in current assets but $25,000,000 in current liabilities.

The company’s working capital ratio is 0.2.

This is an alarming WCR and an investor should further investigate why the company’s WCR has dropped so much to assess risk.

What Is A Good Working Capital Takeaways 

So there you have it folks!

What is considered a good working capital ratio?

The working capital ratio is a quick, easy, and simple way of measuring how well a company is able to meet its short-term obligations using its short-term assets.

In essence, the working capital ratio is a measure of the company’s liquidity and solvency.

In general, a company is considered to have a good working capital ratio when the result is between 1.5 and 2.0.

The optimal working capital ratio may be different for each investor or financial analyst.

Some consider that a healthy working capital ratio is between 2 to 5, others say between 1.2 to 1.5, and so on.

Keep in mind that healthy working capital will probably hover close to 2.0, in general.

A working capital below 1.0 is considered to be an indicator of possible liquidity issues whereas a working capital ratio above 2 may suggest that a company is not utilizing its assets effectively to generate revenues.

Although a working capital ratio of 1.5 to 2.0 is a good rule of thumb indicator of company liquidity, it does not take into account the company’s access to a line of credit and other sources of financing.

I hope I was able to answer your question about what is a good working capital ratio for a company.

Good luck!

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Now, let’s look at a summary of our findings.

What Is A Good Working Capital Ratio Summary

  • Working capital ratio is a measure of liquidity giving a simple perspective of whether or not a business can pay its obligations 
  • A good working capital ratio in the range of 1.5 to 2.0 is considered a good short-term liquidity measure
  • A working capital below 1.0 is seen as an indicator of liquidity problems whereas anything over 2.0 may indicate that the company is not using its assets to maximize revenues
Cash conversion cycle 
Cash flow from sales
Current ratio
Key financial ratios
Liquid assets 
Liquidity ratios
Prepaid expenses
Quick ratio
Solvency ratios
Sustainable growth rate
Unearned revenue 
What are accounts payable 
What are current assets
What are current liabilities 
What is accounts receivable 
What is bad debt
What is cash flow
What is insolvency 
What is secured line of credit
What is unsecured line of credit
What is working capital
Working capital management
Author
Cash flow statement 
Cost of capital 
Current ratio
Dividends per share
Earnings per share
Financial leverage 
Forward PE ratio
Free cash flow 
Gross profit margin
Interest coverage ratio 
Negative retention 
Net operating working capital
Net working capital 
Operating expense ratio
Plowback ratio 
Profit analysis 
Rate of return 
Retained earnings 
Retention growth model 
Return on equity 
Tax retention rate 
Trailing PE
Win/loss ratio 
Working capital turnover
Author
Editorial Staff
Hello Nation! I'm a lawyer by trade and an entrepreneur by spirit. I specialize in law, business, marketing, and technology (and love it!). I'm an expert SEO and content marketer where I deeply enjoy writing content in highly competitive fields. On this blog, I share my experiences, knowledge, and provide you with golden nuggets of useful information. Enjoy!

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