Working Capital Ratio

The working capital ratio is a widely used indicator of short-term financial health. It measures whether a company has enough current assets to cover its current liabilities. A strong ratio reflects efficient management of resources, while a weak one signals potential liquidity issues.

The working capital ratio, also known as the current ratio, shows how effectively a company can meet its short-term obligations with its short-term assets. It is calculated by dividing current assets by current liabilities.

A ratio greater than 1 indicates that the company has more assets than liabilities, suggesting financial strength. Conversely, a ratio below 1 means the business may struggle to pay its debts as they come due.

The formula for calculating the working capital ratio is straightforward:

Working Capital Ratio = Current Assets ÷ Current Liabilities

Where:

• Current Assets = Cash, accounts receivable, and inventory
  

• Current Liabilities = Accounts payable, short-term debt, and accrued expenses
  

For example, if a company has ₹500 Crores in current assets and ₹250 Crores in current liabilities, its working capital ratio is:

Working Capital Ratio = ₹500 ÷ ₹250 = 2.0

This means the company has twice as many assets as liabilities, which is a sign of strong liquidity.

Let’s consider a company with the following balance sheet data:

• Current Assets: ₹800 Crores
  

• Current Liabilities: ₹600 Crores
  

Working Capital Ratio = ₹800 ÷ ₹600 = 1.33

This indicates that for every ₹1 of liabilities, the company has ₹1.33 of assets. This ratio indicates adequate liquidity, although companies often target 1.5–2.0 for optimal stability.

The working capital ratio is vital for evaluating short-term financial health.

• Assesses whether a company can cover its short-term debts without difficulty
  

• Helps investors and creditors gauge liquidity before extending credit or investment
  

• Reflects efficiency in managing receivables, inventory, and payables
  

• Provides early warning signals of financial stress if the ratio falls below acceptable levels
  

Despite being widely used, the working capital ratio has certain limitations.

• Does not assess the quality of assets, such as how quickly receivables can be collected
  

• Very high ratios may indicate underutilisation of assets or overly conservative management
  

• Seasonal businesses may show fluctuating ratios that do not reflect long-term health
  

• Cannot be used in isolation; other ratios like quick ratio or cash ratio are needed for a fuller picture

The working capital ratio is a key financial metric for measuring liquidity. A balanced ratio suggests that the company is managing its resources effectively, while extreme values (too low or too high) may indicate inefficiencies. Investors, lenders, and management should use this ratio alongside other indicators for a comprehensive view of financial stability.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.