The working capital ratio is one of the most basic measures of a company’s liquidity, or, in other words, a company’s ability to meet its short-term financial obligations. The ratio is defined as the difference between current assets and current liabilities (it is sometimes referred to as the current ratio).
If you are considering investing in a company, you need to be diligent about understanding these two aspects. The foundation of a company’s strategy may be solid and its prospects good, but a profitable long-term approach will not prevent it from going bankrupt within weeks or months. That can only be accomplished by keeping a close eye on cash flow and adjusting as the situation dictates.
Calculating Working Capital Ratio
While the formula for working capital ratio is simple — it is calculated by dividing current assets by current liabilities — it represents an enormous amount of data and can have serious implications for a company’s continued operations. Some pieces of information are useful and others are not, and knowing the difference is essential for providing a clear picture of the short-term financials. As an investor, you need to look closely at what data a company has used to calculate its working capital ratio to ensure the truth of the situation is not obscured.
When embarking on this kind of due diligence, it is equally important to handle sensitive information responsibly. Virtual data rooms provide fully secure spaces for these kinds of disclosures.
Defining Current Assets and Current Liabilities
To properly assess working capital ratio, it’s important that current assets be distinguished from longer-term investments. The word “current” in this context is shorthand because these numbers can change based on day-to-day operations, whereas long-term investments tend to be more fixed.
In practical terms, a current or short-term asset is one that can be converted into cash within 12 months, such as inventories or accounts receivable. Conversely, a current liability is an obligation that will come due within 12 months, such as accounts payable or a line of credit from the bank. These assets and obligations change on an ongoing basis and should be understood as a reflection of the company’s habits rather than a portrait of its potential long-term viability.
How High Should Working Capital Ratio Be?
Generally speaking, a working capital ratio of 1.5:1 to 2:1 indicates that a company is in good shape financially. It may seem to follow intuitively that the higher capital ratio a company has the better, but this is not the case. A ratio above two means that a company has plenty of cash on hand, but having all that cash can also mean that the company is not doing a good job of reinvesting its assets to increase revenue.
Something else to consider is that because working capital ratio is a snapshot of a company’s cash flow, a single sample of it may not be enough to make an accurate assessment. It is probably worth comparing the most recent figures against the company’s historical norms and then repeating the measure over several periods before determining whether or not you want to invest.
What Is Negative Working Capital?
As the name suggests, if a company has a negative working capital, its obligations outweigh its assets and it may be on the path to bankruptcy. However, bear in mind that this ratio reflects day-to-day operational behaviors, which means that those behaviors can be changed as well as the ratio. A negative ratio that is not too extreme can be remedied and should not necessarily prevent you from investing.
It is also worth noting that historically, there have been examples of very successful companies carrying negative capital ratios for a long time yet still being successful. Perhaps the most famous case study is Dell, whose business model allowed them to manufacture and sell computers directly to consumers while carrying their suppliers’ obligation.
High volume sales meant that though they had negative capital they were always able to meet their obligations without dipping into their savings. In fact, businesses of certain types, such as online retailers, discount retailers and telecom companies, are sometimes expected to have negative capital ratios.
Working Capital Ratio Is Not the Only Useful Metric
The working capital ratio can help you avoid certain pitfalls, but it is worth remembering that it does not provide all the information you might need about a company.
For example, if you suspect that a company’s working capital ratio is too high, another measure, known as return on assets (ROA), can be used as a follow-up. ROA is determined by dividing a company’s net income by total assets. If a company has a high working capital ratio and a low ROA, there may be a problem.
Another limitation of working capital ratio is that it does not take into account the ability of any company to honor its obligations on a staggered schedule. When you measure liquidity, you inherently suppose a situation in which all of a company’s assets must be converted to cash at once to satisfy all of its liabilities, a situation that almost never occurs.
Keeping an Eye on Working Capital During M&A
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Rafael Carillo is a writer, editor and tutor living in Brooklyn.