Working Capital Ratio Analysis | Efficiency Ratio

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Working Capital Ratio

 The working capital ratio is similar to the current ratio. It measures a business’s ability to repay its current liabilities with 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 of 2.0 is considered to represent good short-term liquidity.

Current liabilities are best paid with current assets like cash, cash equivalents, and marketable securities because these assets can be converted into cash much quicker than fixed assets. The faster the assets can be converted into cash, the more likely the company will have the cash in time to pay its debts.

When current assets go above current liabilities, the firm has enough capital to run its daily operations. We can say, it has sufficient capital to work. The working capital ratio converts the working capital calculation into a comparison between current assets and current liabilities.

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Working Capital Ratio Formula

The formula is very simple you can calculate working capital ratio by dividing current assets by current liabilities.

Working Capital Ratio formula

 Working Capital Ratio Example

  • Current Assets Increase = Increase in WCR
  • Current Assets Decrease= Decrease in WCR
  • Current liabilities Increase = Decrease in WCR
  • Current Liabilities Decrease = Increase in WCR

TOYO Co Machine Shop has some loans from banks for tools he purchased in the last 10 years. All of these loans are coming outstanding which is decreasing his working capital. At the end of the year, TOYO Co had $250,000 of current liabilities & $200,000 of current assets.

Working Capital Ratio Example

Working Capital Ratio is less than 1 it means his debt is increasing. It shows that his business is more risky to new potential credits. If TOYO Co wants to apply for an extra loan, he should repay some of the liabilities to lower his WCR before he applies.

Working Capital Ratio Scrutiny/Analysis/Interpretation:

The working capital ratio measures current assets as a percentage of current liabilities, it would only make sense that a higher ratio is more favorable. A WCR of 1 indicates the current assets equal current liabilities. A ratio of 1 is usually considered the middle ground. It’s not risky, but it is also not very safe. This means that the firm would have to sell all of its current assets in order to pay off its current liabilities.

A ratio less than 1 is considered risky by creditors and investors because it shows the company isn’t running efficiently and can’t cover its current debt properly. A ratio less than 1 is always a bad thing and is often referred to as negative working capital.

On the other hand, a ratio above 1 shows outsiders that the company can pay all of its current liabilities and still have current assets left over or positive working capital.