The Working Capital Ratio: Formula & Use

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  • 0:03 The Working Capital Ratio
  • 2:17 Liquidity
  • 3:12 Lesson Summary
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Instructor: Martin Gibbs

Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.

This lesson will explain the process for calculating the working capital ratio. We'll provide examples and explain what the ratio means, including its role as a measuring stick for financial performance.

The Working Capital Ratio

The working capital ratio, also called the current ratio, is a barometer for a company's short-range financial health. When you compute the working capital ratio, you're testing whether a company has the short-term assets necessary to pay for any short-term obligations or debts. On the balance sheet, these obligations are called current liabilities. We'll get into the details shortly, but the working capital ratio formula is calculated as:

  • Working Capital Ratio = Current Assets / Current Liabilities

In order to understand this better, let's look at a sample company, whose stock symbol is IMI. Looking at the balance sheet data for 2016, we find current assets at 32,254,000 and current liabilities of 4,956,000. This gives us a ratio of 6.5. While it sounds great, let's explore what the number means.

Many analysts feel that a ratio between 1.2 and 2.0 is an ideal target. A number less than 1 indicates that the company will have problems paying off short-term debts. However, a number above 2 isn't that wonderful either. It usually means excess assets aren't being invested.

In the IMI example, the high working capital ratio might indicate that IMI has too much inventory or is not investing any excess cash. Furthermore, the number keeps creeping up - the value for 2015 was around 4. Money might be tied up in accounts receivable, or inventory, and thus it can't be used to pay off debts.

So what impacts the working capital ratio? We know that it compares current assets to current liabilities. The following table highlights how each moving part affects the other.

working capital ratio movement

As this table shows, if the liabilities of a company increase, then the working capital ratio decreases. Conversely, if the liabilities of a company decrease, then the working capital ratio increases. Likewise, if the assets of a company increase, then the working capital ratio increases, but if the assets of a company decrease, then the working capital ratio decreases.

Basically, it is important to be able to have enough current assets to offset current liabilities. Movement in each bucket impacts the working capital ratio.

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