The working capital ratio, also known as the current ratio, is a financial metric that measures a company’s ability to pay off its current liabilities with its current assets.
Primary Implication
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
Checking Your Business’s Financial Health: The Working Capital Ratio
The Working Capital Ratio (also known as the Current Ratio) is a quick way to see how easily a company can pay its short-term debts. It compares a business’s current assets (things like cash, inventory, and what customers owe) to its current liabilities (like short-term loans and bills).
What the Working Capital Ratio Tells You
A healthy ratio means the company has more than enough to cover its immediate debts. A higher ratio means a bigger safety net. For example, a ratio of 4 means the company has $4 in current assets for every $1 of current liabilities.
Things to Watch Out For
- Too High: A very high ratio might mean the company isn’t using its assets effectively.
- Too Low: A low ratio could signal trouble paying bills or problems with collecting payments from customers.
Working Capital Ratio Formula
Current Assets / Current Liabilities
Interpreting the Working Capital Ratio
- Above 1: The company has enough to cover its short-term debts and has extra for investing in the business.
- Below 1: The company might struggle to pay its bills on time because Current Liabilities are too high relative to Current Assets.
