Interpreting the Working Capital Ratio

A company's working capital ratio is a measure of its short-term ability to cover its financial liabilities. Working capital ratio is found through the formula: current cash assets divided by current liabilities. It can also be found with the formula: current cash assets minus current liabilities. In both models, a company aims to have current cash assets far exceeding current liabilities. However, having little to no liabilities is not necessarily a sign of success. Consider these factors when interpreting working capital ratio. 

Negative Ratio

If you are using the formula for the working capital ratio that divides assets by liabilities, you will want to find companies that have a working capital ratio that is a whole number higher than one. This means the company has enough assets to cover its liabilities in the present. With the subtraction model, the goal is to have a working capital ratio higher than zero. A negative working capital ratio means a company, if it had to pay off all its creditors today, could not do so. While this demand is not often a reality, companies with current cash assets under their current cash liabilities may have difficulties paying creditors, and they may even face bankruptcy in a worst case scenario.

Zero Liabilities

Having a low amount of liabilities may be the safest route for a company to take, but it is not necessarily the smartest. Consider another factor used to extrapolate a company's profitability: return on assets. In this model, assets include liabilities. An analyst using the ROA (Return On Assets) to measure a company's profitability is measuring how well a company has leveraged assets, putting capital to work through debt financing in order to grow. A company that does not take this step, though it may grow, will grow significantly slower than a company that leverages wisely.

Interpreting Working Capital Ratio

A company with a very low working capital ratio is at risk of bankruptcy. A company with too high a ratio is not doing enough to put its assets to work. The goal, then, is to find a company whose asset ratio reflects an ability to immediately meet all current liabilities but just barely in most cases. For example, an electric company runs a low risk of slow business cycles. On the whole, no matter what occurs in the market, an electric company is going to get paid. For this reason, an electric company does not need a large amount of reserve assets. As long as that company can cover its current liabilities, it is considered to be in solid financial shape.

A car manufacturer is highly susceptible to decreased profits in a recession or a slow business cycle. This company, even if it has enough cash to cover current liabilities, needs a large amount of reserve capital in case the market takes a downturn. For this reason, a car manufacturer should aim to have a higher working capital ratio than a utilities company. When you interpret this figure, always take the industry and company into account in order to view its stability based on working capital ratio.

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