The working capital ratio aslo kniown as current ratio, is a liquidity ratio that calculates a firm’s ability to clear off its current liabilities with current assets. The working capital ratio is a significant factor to creditors because it reflects the liquidity of the business firm.

Current assets like cash, cash equivalents, and marketable securities are best suited to clear off the current liabilities because these assets can be converted into cash much faster and easier than fixed assets. The quicker the assets convert into cash, the more chances the company will have the cash in time to clear off its debts.

The formula to calculate Working Capital Ratio is:

Working Capital Ratio = Current Assets/Current Liabilities

Both the accounts i.e. current assets and current liabilities are mentioned separately from their respective long-term accounts on the balance sheet. This presentation gives investors and creditors a better picture to examine about the company. Current assets and liabilities are always priorly mentioned in the financial statements followed by long-term assets and liabilities.

This calculation shows accurately what percentage a firm’s current assets are of its current liabilities.

Implication

Since the working capital ratio caculates current assets as a percentage of current liabilities, it is quite clear that a higher ratio is more beneficial. A WCR of 1 indicates that the current assets and current liabilities are equal. A ratio of 1 is generally treated as neutral. It does sound safe but actually it isn’t because that would mean that the firm will have to sell all of its current assets in order to clear off its current liabilities.

A ratio less than 1 is considered unfavourable especially by creditors and investors because it clearly indicates that the company’s functioning is not effective enough and can’t pay off its current debt properly. A ratio less than 1 is never a good thing and is often referred to as negative working capital.

On the contrary, a ratio more than 1 indicates outsiders that the company can clear all of its current liabilities and still have current assets left on their side  which is also referred to as positive working capital.

Example

Consider this example. ABC’s Machine store has some loans from banks for equipment he purchased in the last five years. All of these loans are matured to the due time which is decreasing his working capital. At the end of the year, ABC had $100,000 of current assets and $125,000 of current liabilities. Here is his WCR:

WCR: $100,000/$1,25,000

WCR: 0.80

The above figure of WCR is less than 1 because his debt is increasing. This makes his firm more risky to new potential credits. If ABC wants to apply for another loan, he will have to pay off some of the liabilities to lower his working capital ratio before he applies.