Last editedSep 20222 min read
Understanding your company’s performance requires learning about a number of different metrics, each of which can give you an insight into different areas of the business. One important financial measure of your performance is known as working capital ratio, which is a good indicator of your liquidity, operational efficiency and also your short-term financial health.
But what is working capital ratio, and what is the working capital ratio formula? In simple terms, it’s the difference between your company’s current assets (that is, things with financial value that you own or are owed) and its liabilities, such as loans to repay. Keep reading to find out more about working capital and current ratio.
What is working capital ratio?
In a nutshell, you can understand working capital ratio (also known as working capital turnover ratio) as a measure of how much money your business has available to pay for regular financial obligations such as your employees’ salaries and overheads of running your business. It’s a good indicator of how much cash your company has available and your current financial performance.
In more detail, the working capital ratio formula compares your company assets to your current liabilities, providing a simple measure of how much you have compared to how much you owe. For example, assets include cash, accounts receivable, stock, prepaid expenses, and short-term investments, whereas liabilities will include accounts payable, overdrafts, wages, rent and any short-term loans.
How do you calculate working capital turnover ratio?
The way to calculate working capital ratio is actually quite simple, and there are two different measures that you should be aware of. To calculate just your working capital, you simply subtract the financial value of your current liabilities from your current assets. So, if you have $150,000 in assets and $75,000 in liabilities, then your working capital is $75,000.
The working capital ratio is slightly different, as it shows the relationship between assets and liabilities proportionally. To calculate this, you should divide your current assets by your current liabilities. So, using the same figures from before ($150,000 in assets and $75,000 in liabilities) would produce a working capital ratio of 2.
What is a good working capital ratio?
It’s important to know how to calculate your working capital ratio, but it’s even more important to understand how to interpret this. So, what is a good working capital ratio?
Since the ratio shows the relationship between your assets (the financial value that your company owns) and your liabilities (the financial value that you owe to others), a higher ratio is better. This indicates that you have more cash available to pay off financial obligations, and therefore likely have a better overall cash flow.
As a rule of thumb, if your company has a working capital ratio of less than 1, then this may indicate that you are facing liquidity problems. Anywhere between 1.2 and 2 is considered an ideal range for the working capital ratio. On the other hand, if your ratio is above 2, then it might mean you are holding on to assets when you should be investing them to encourage growth of the company.
Is current ratio and working capital ratio the same?
When they learn about these metrics, many business owners wonder: is current ratio and working capital ratio the same? Indeed, current ratio is just another term for working capital ratio, and is calculated by dividing the company’s assets by their liabilities.
Confusion can sometimes arise here as working capital (the actual difference between liabilities and assets) is always referred to in the same way, but the ratio has two separate terms: current ratio and working capital ratio.
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