Banking Financial Analysis

Working Capital Ratio

What is working capital ratio?

Working Capital Ratio is the day-to-day fund requirements for the trading operations of a company. It measures a company’s financial health.

This is because if an organization cannot manage to pay money for its day to day activities, it would not be ready to see a protracted-term future.

It is also at times known as revolving capital / circulating capital / short-term capital as it caters to the short-term financing needs of a business.

This ratio is important to creditors because it shows the liquidity of the company. With the help of this ratio we are using a working capital calculation that’s why it called Working Capital Ratio.

It is also called the current ratio, which is a liquidity ratio that measures a firm’s ability to pay off its current liabilities with current assets.

Cash, cash equivalents, and marketable securities are best for pay off the current liability. These assets can be changed into liquid money much quicker than fixed assets.

The faster the assets are often converted into cash, the more likely the organization will have the take advantage of liquid cash at the time to pay its debts.

Read| Current Ratio

Advantage of Working capital Ratio

  1. Proper application of a working capital management strategy would enhance the company’s profitability within the long-standing time.
  2. Increasing Investment Effectiveness
  3. Improving Operating Efficiency
  4. Helps in Running Business Smoothly
  5. Measures the liquidity of the company.
  6. Necessary to ensure uninterrupted operations
  7. Indicates how capable a company is of meeting its current financial obligations
  8. Measurement of a company’s basic financial solvency
  9. Represents the financial position of a company.
  10. This represents the liquidity of a company.
  11. It represents the margin of safety.
  12. Gives an idea of a company’s operating cycle.
  13. Shows the management’s efficiency in meeting the creditor’s demands.
  14. It enables the organization to plan inventory storage mechanisms and optimize the overhead costs.

Disadvantage of Working Capital Ratio

  1.  Excess working capital lying with the company earns no interest and therefore it can be termed as zero return capital.
  2. It is not a prudent financial decision on the part of the company.
  3. Purchasing unnecessary things due to excess capital is one of the limitations.
  4. A low ratio limits your ability to make and quickly enact decisions.
  5. Low capital may hold back your ability to meet short-term expense and debt repayment obligations of the firm.

Formula

working-capital-ratio

working-capital-ratio

Analysis and Interpretation of Working Capital Ratio

Since the capital ratio measures current assets as a percentage of current liabilities, it might only add up that a better ratio is more favorable. A WCR of 1 represents the current assets equal to current liabilities.

A ratio of 1 is sometimes considered the center-ground. It’s not risky, but it is also not very safe. This means that the firm would have to be compelled to sell all of its current assets so as to pay off its current liabilities.

A ratio of less than 1 is taken into account risky by creditors and investors because it shows the organization isn’t running efficiently and can’t cover its current debt properly.

A ratio of less than 1 is often a foul thing and is usually mentioned as a negative working capital.

A ratio above 1 indicates outsiders that the firms can pay all of their current liabilities and still have working assets leftover or positive working capital.

Since the 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

Example

Let’s say XYZ is a company having current assets $12000 and current liabilities $10000. Then a bank manager wants to calculate WCR as

working-capital-ratio

working-capital-ratio

= $12000 / $10000

= 1.20

Above ratio 1.20 shows outsiders that the company can pay all of its current liabilities and still have current assets leftover or positive working capital.

 

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