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: Since the working capital ratio has two main moving parts, assets and liabilities, it is important to think about how they work together. 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.
A ratio less than 1 is always a bad thing and is often referred to as negative working capital. This means that the firm would have to sell all of its current assets in order to pay off its current liabilities.Ī 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. It’s not risky, but it is also not very safe. A ratio of 1 is usually considered the middle ground. A WCR of 1 indicates the current assets equal current liabilities. 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. 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. This makes her business more risky to new potential credits. Here is her WCR:Īs you can see, Kay’s WCR is less than 1 because her debt is increasing. At the end of the year, Kay had $100,000 of current assets and $125,000 of current liabilities. All of these loans are coming due which is decreasing her working capital. Kay’s Machine Shop has several loans from banks for equipment she purchased in the last five years. This calculation gives you a firm understanding what percentage a firm’s current assets are of its current liabilities. Current assets and liabilities are always stated first on financial statements and then followed by long-term assets and liabilities. This presentation gives investors and creditors more information to analyze about the company. The working capital ratio is calculated by dividing current assets by current liabilities.īoth of these current accounts are stated separately from their respective long-term accounts on the balance sheet. The working capital ratio transforms the working capital calculation into a comparison between current assets and current liabilities. In other words, it has enough capital to work. When current assets exceed current liabilities, the firm has enough capital to run its day-to-day operations. The reason this ratio is called the working capital ratio comes from the working capital calculation. 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 working capital ratio is important to creditors because it shows the liquidity of the company.Ĭurrent 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. 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.
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