What Is A Good Working Capital Ratio?
What is a healthy working capital ratio for companies?
How does it work?
In this article, I will break down the question What Is A Good Working Capital Ratio so you know all there is to know about it!
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
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.
My Investing, Business, and Law Blog
By the way, on this blog, I focus on topics related to starting a business, business contracts, and investing, making money geared to beginners, entrepreneurs, business owners, or anyone eager to learn.
I started this blog out of my passion to share my knowledge with you in the areas of finance, investing, business, and law, topics that I truly love and have spent decades perfecting.
You may find useful nuggets of wisdom to help you in your entrepreneurship journey and as an investor.
I’d love to share the insider knowledge that I’ve acquired over the years helping you achieve your business and financial goals.
Now, let’s look at a summary of our findings.
What Is A Good Working Capital Ratio Summary
If you enjoyed this article on What Is A Good Working Capital Ratio, I recommend you look into the following terms and concepts. Enjoy!
You May Also Like Related to Good Working Capital Ratio
Cash conversion cycle
Cash flow from sales
Key financial ratios
Sustainable growth rate
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
Related to Working Capital And Financial Ratios
Cash flow statement
Cost of capital
Dividends per share
Earnings per share
Forward PE ratio
Free cash flow
Gross profit margin
Interest coverage ratio
Net operating working capital
Net working capital
Operating expense ratio
Rate of return
Retention growth model
Return on equity
Tax retention rate
Working capital turnover