What is Working Capital?
Definition: The working capital ratio, also called the current ratio, is a liquidity ratio that measures a firm’s ability to pay off its current liabilities with current assets. The working capital ratio is important to creditors because it shows the liquidity of the company.
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.
The reason this ratio is called the working capital ratio comes from the working capital calculation. When current assets exceed current liabilities, the firm has enough capital to run its day-to-day operations. In other words, it has enough capital to work. The working capital ratio transforms the working capital calculation into a comparison between current assets and current liabilities.
The working capital ratio is calculated by dividing current assets by current liabilities.
Both of these current accounts are stated separately from their respective long-term accounts on the balance sheet. This presentation gives investors and creditors more information to analyze about the company. Current assets and liabilities are always stated first on financial statements and then followed by long-term assets and liabilities.
This calculation gives you a firm understanding what percentage a firm’s current assets are of its current liabilities.
Let’s take a look at an example.
Let’s take a look at an example. Kay’s Machine Shop has several loans from banks for equipment she purchased in the last five years. All of these loans are coming due which is decreasing her working capital. At the end of the year, Kay had $100,000 of current assets and $125,000 of current liabilities. Here is her WCR:
As you can see, Kay’s WCR is less than 1 because her debt is increasing. This makes her business more risky to new potential credits. If Kay wants to apply for another loan, she should pay off some of the liabilities to lower her working capital ratio before she applies.
Analysis and Interpretation
Since 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.
Since the working capital ratio has two main moving parts, assets and liabilities, it is important to think about how they work together. In other words, how does the ratio change if a firm’s current liabilities increase while the current assets stay the same? Here are the four examples of changes that affect the ratio:
- Current assets increase = increase in WCR
- Current assets decrease= decrease in WCR
- Current liabilities increase = decrease in WCR
- Current liabilities decrease = increase in WCR
Practical Usage Explanation: Cautions and Limitations
Positive vs. Negative Working Capital
Positive working capital is always a good thing because it means that the business is about to meet its short-term obligations and bills with its liquid assets. It also means that the business should be able to finance some degree of growth without having to acquire and outside loan or raise funds with a new stock issuance.
Negative working capital, on the other hand, means that the business doesn’t have enough liquid assets to meet it current or short-term obligations. This is often caused by inefficient asset management and poor cash flow. If the business does not have enough cash to pay the bills as they become due, it will have to borrow more money, which will in turn increase its short-term obligations.
Is Negative Working Capital Bad?
Negative working capital is never a sign that a company is doing well, but it also doesn’t mean that the company is failing either. Many large companies often report negative working capital and are doing fine, like Wal-Mart.
Companies, like Wal-Mart, are able to survive with a negative working capital because they turn their inventory over so quickly; they are able to meet their short-term obligations. These companies purchase their inventory from suppliers and immediately turn around and sell it at a small margin.
Accounting & CPA Exam Expert
Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career.