How to Calculate Working Capital Ratio?

Working capital ratio or current ratio is a financial ratio to measure company's ability to pay off its short-term liabilities through short-term assets. 

Table of Contents

• How To Calculate Working Capital Ratio
• What Does Working Capital Ratio Indicate?
• Impact of Low Working Capital Ratio
• Impact of High Working Capital Ratio
• Strategies To Improve Working Capital Ratio

Before understanding the working capital ratio, let us understand working capital. 

Imagine you own a lemonade stand. To start selling, you need lemons, sugar, water, and cups. These items are your current assets. You also have some bills to pay, like rent for the table. These bills are your current liabilities. Working capital is the difference between what you have i.e. assets and what you owe i.e. liabilities.

So, if you have ₹100 worth of lemons, sugar, water, and cups, and you owe ₹30 for the table rental, your working capital is ₹70. This ₹70 is what you can use to keep the stand running, like buying more supplies or covering unexpected costs. It's the money you have on hand to make your lemonade stand operate smoothly day to day.

How to Calculate Working Capital Ratio?

You have ₹100 in lemons, sugar, water, and cups (your current assets), and you owe ₹30 for the table rental (your current liabilities). The working capital ratio will be calculated by dividing current assets with current liabilities.

In this case, your working capital ratio would be ₹100 divided by ₹30, which equals approximately 3.33. This ratio tells you that for every rupee of liability, you have over three rupees in assets. It means you're in a good position to cover your short-term debts and still have assets left.

• If working capital ratio is equal to 1, then current assets = current liabilities, suggesting it has just enough resources to meet its short-term obligations.
• If this ratio is greater than 1, the company has more current assets as compared to current liabilities, suggesting good short-term financial health.
•  A ratio less than 1 indicates that company has more current liabilities compared to current assets. It suggests short-term liquidity issues.

What Does Working Capital Ratio Indicate?

The working capital ratio indicates the company's financial health. It also indicates the company's ability to manage its short-term commitments. It also indicates the following things:

• Liquidity: It measures a company's ability to cover its short-term obligations with its short-term assets. A higher ratio means better liquidity.
• Financial Stability: A ratio above 1 suggests the company can meet its short-term liabilities without selling long-term assets, indicating stability.
• Risk Assessment: Creditors and investors use this ratio to assess the risks involved in either lending money to your company or investing in your company.
• Operational Efficiency: It can also reflect on a company's operational efficiency in managing its assets and liabilities.

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Impact of Low Working Capital Ratio

The following points indicate the impact of a low working capital ratio:

• Increased Financial Risk: A low working capital ratio indicates higher risk of defaulting on short-term obligations.
• Potential Liquidity Issues: It suggests the company might struggle to convert assets into cash quickly to meet immediate liabilities.
• Limited Growth Opportunities: With limited working capital, a company may struggle to invest in new projects or expansion efforts.
• Poor Creditworthiness: Creditors may view the company as a higher risk, leading to difficulties in securing loans or favorable credit terms.
• Operational Challenges: The company might face challenges in maintaining day-to-day operations due to a lack of readily available funds.
• Supplier and Vendor Relations: Difficulty in timely payment to suppliers can strain relationships and potentially disrupt supply chains.
• Investor Concerns: Investors may see a low working capital ratio as a sign of poor financial health, affecting investment and stock prices.

Impact of High Working Capital Ratio

The following points indicate the impact of high working capital ratio:

• Easily Pay Bills: It means the company can easily pay off its short-term debts.
• Inefficient: The company could be holding more items or money than needed, which is not always efficient. Money that is saved in the bank could be used elsewhere to generate more income or grow the business. More items mean higher costs for storage. These costs can eat into profits, especially if the inventory does not sell quickly.
• Missed Opportunities: Extra money could be used for new projects or making more money, so too high a ratio might mean missed opportunities. 
• Waste of Resources: If the ratio is too high, it might indicate the company is not using its resources properly.
• Easier to Get Loans: Companies with a high ratio can get loans easily and on better terms.
• Handling Unexpected Situations: The company can handle unexpected needs or opportunities without borrowing more money.
• Better Business Relationships: Being able to pay suppliers on time can make these business relationships stronger.

Strategies to Improve Working Capital Ratio

The following are the strategies to improve the working capital ratio:

1. Inventory Management: Reduce excess stock to free up cash. Implement just-in-time inventory to minimize holding costs.
2. Receivables Management: Speed up the collection of payments. Use incentives for early payments and follow up on late payments promptly.
3. Payables Management: Negotiate longer payment terms with suppliers without incurring penalties to keep cash longer.
4. Cash Flow Monitoring: Regularly review cash flow statements to identify and address any inefficiencies.
5. Short-term Financing: Take short-term loans to cover temporary shortfalls without compromising liquidity.
6. Asset Utilization: Sell off underused or obsolete assets to generate cash.
7. Cost Control: Review and reduce unnecessary expenses to improve profitability and cash flow.
8. Improve Sales: Increasing sales through marketing or new product lines can boost current assets.
9. Lease Instead of Buy: Leasing equipment rather than purchasing can keep more cash in the business.
10. Efficient Billing System: Implement an efficient billing system to ensure invoices are sent out promptly.