Every business has a limited time to raise the funds needed to pay their most common liabilities. The best measure of your ability to pay back current liabilities over the next 12 months is with current assets.
The higher the Working Capital Ratio, the greater the cash “cushion” to cover your obligations. On the other hand, if this ratio is too high, you aren’t likely using your current assets efficiently.
Overview
The Working Capital or Current Ratio is a Liquidity Ratio mainly used to gauge the company’s ability to pay back its liabilities with its current assets over the next 12 months. This ratio compares a firm’s current assets (cash, marketable securities, inventory, accounts receivable) to its current liabilities (short-term debt and accounts payable).
Every business has limited time to raise funds to pay for their most common liabilities. The higher the Current Ratio, the greater the “cushion” to cover its obligations. If the Current Ratio is too high, the company may not efficiently use its current assets.
In contrast, a low Current Ratio is usually the result of poor collections and accounts receivable processing. It is very unfavorable to have a negative Working Capital Ratio. This ratio also sheds light on the overall debt burden of the company. When its current assets exceed current liabilities, the firm should have enough capital to run its day-to-day operations. If a company is weighted down with current debt, its cash flow will suffer.
The formula for calculating the Working Capital or Current Ratio is as follows:
Current Assets / Current Liabilities
If current liabilities exceed current assets, the current ratio will be less than one (< 1), challenging the company’s ability to meet its short-term obligations. A current ratio of 4 would mean that the company has four times more current assets than current liabilities.
Above 1: means that the company can pay all of its current liabilities and still have current assets or positive working capital to invest in other areas of the business.
Less than 1: shows the company isn’t running efficiently and can’t cover its current debt out of its current assets.