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Working capital, also known as, net working capital is an important component for every business, no matter how big or small. This is a crucial financial metric that every business should keep an eye on. Timely working capital analysis helps in maintaining the required cash flow which inturn is essential for smooth management of business operations. Moreover, determining working capital can also help in evaluating the financial health of a business, its creditworthiness and securing loans.
It is often seen that some businesses struggle not because they lack cash, but due to poor management of their working capital. This can result in missed payments, operational delays, lost opportunities, and reduced profits. That’s why the working capital ratio is so important. It’s a key measure of liquidity that every business should use to stay financially healthy.
Read on as we discuss in detail what is working capital ratio, what is the ideal ratio and why is determining working capital so important.
Determining a Good Working Capital Ratio
Knowing the ideal working capital turnover ratio can help businesses assess whether their assets are sufficient to cover short-term financial obligations while maintaining adequate reserves for day-to-day operations. Let’s get into the details.
- Understand the Importance of Working Capital and Its Role in Determining a Company’s Liquidity
Working capital plays a crucial role in maintaining a business’s financial health and smooth operations. Effective management ensures timely payments to suppliers and employees, avoiding disruptions in daily activities. Additionally, it offers flexibility to seize growth opportunities and handle unexpected expenses with ease, supporting overall business success.Additionally, positive working capital boosts creditworthiness, making it easier to secure loans and negotiate favourable credit terms. Furthermore, having sufficient working capital reduces the need for costly short-term borrowing, helping businesses manage expenses more effectively.
- Calculate the Working Capital Ratio to Assess a Company’s Ability to Meet Short-Term Obligations
Here is the net working capital ratio formula:Current Assets ➗Current Liabilities
So, for example, if a company has ₹10 lakhs in its current assets and ₹4 lakhs as its current liabilities, its working capital ratio would be 1.66. Typically, a ratio/ score between 1.5 and 2.1, indicates that a company is financially stable. This suggests the business has sufficient funds available, whether it is from timely customer payments, bank balances, or financing options. It shows that the company is able to meet its obligations, such as covering lease expenses or paying employees, without stress.
What Does the Working Capital Ratio Indicate About Liquidity?
The working capital requirements of a business depend on factors such as its industry, size, and risk profile. Industries with lengthy production cycles typically need higher working capital due to slower inventory turnover. In contrast, large retail companies dealing with a high volume of daily customer transactions can quickly generate short-term funds and usually require less working capital.
- Interpret the Working Capital Ratio as a Measure of a Company’s Efficiency in Managing Its Assets and Liabilities
Simply put, working capital is the difference between a company’s current assets and current liabilities. It reflects the company’s ability to manage short-term financial obligations while maintaining smooth day-to-day operations.A positive working capital indicates healthy liquidity, ensuring the business can cover immediate expenses like payroll, supplier payments, and overhead costs. On the other hand, a negative working capital can signal potential cash flow problems, hindering the company’s ability to meet short-term liabilities.
- Identify the Relationship Between the Working Capital Ratio and Cash Flow
Working capital ratio and cash flow are often used interchangeably, but these metrics differ from each other. As discussed working capital is the balance that remains after subtracting the company’s liabilities from its assets. Cash flow on the other hand refers to the company’s liquidity. It is the movement of money resulting from financial transactions.
Measuring Liquidity Through the Cash Conversion Cycle
The cash conversion cycle (CCC), also known as the net operating cycle or cash cycle, measures the time a company takes to sell inventory, collect payments from customers, and settle its obligations.
This metric indicates how many days it takes to turn the cash invested in inventory into cash received from sales. A shorter cycle is generally preferred, as it means cash spends less time in inventory or accounts receivable.
What Is a Healthy Amount of Working Capital?
An ideal working capital ratio typically falls between 1.5 and 2.1, indicating strong financial health and sufficient liquidity. A score higher or lower can reflect some financial issues with the company. Therefore, one needs to:
- Determine an Acceptable Working Capital Ratio Based on Industry Standards and Business Context
A high or positive working capital ratio, typically greater than 1, indicates that a business is in a solid financial position with strong liquidity and solvency. It reflects the company’s ability to cover its short-term liabilities with sufficient current assets.
On the other hand, an excessively high ratio may suggest that the business is holding too much idle cash, which could have been more efficiently utilized through reinvestment to generate higher returns.A working capital ratio below one signifies a deficit, where current liabilities surpass current assets, leading to negative cash flow. This situation often arises from factors like declining sales revenue, poor inventory management, or challenges with accounts receivables. Such a ratio indicates potential difficulties for the business in meeting its financial obligations to lenders.
- Consider Factors Such as Seasonality, Growth Stage, and Business Model
When doing a working capital ratio analysis, it is essential to remember that a low ratio may not always be a bad thing. There are some other factors that play a role.For instance, businesses that are season-specific may see a rise in sales only during some specific months. The working capital to sales ratio may keep varying. Similarly, the growth stage of the company can also affect the working capital turnover ratio. For example, the working capital needs of a smaller business with limited production may have smaller working capital needs.
Is 4.0 a Good Working Capital Ratio?
At the face of it, if working capital ratio is 4, it may seem that the company is doing very well. However, it is not really like that. Keep in mind the following points:
- Understand That There Is No Definitive Answer to Whether a 4.0 Working Capital Ratio Is Good or Bad
A high score is not always the ideal working capital turnover ratio. It can negatively impact long-term business performance and suggest that the company is not utilising its surplus current assets effectively, which could result in a lower return on assets (ROA). This key profitability metric is vital for investors and stakeholders in evaluating a company’s financial health and performance. - Evaluate the Ratio in Context With Other Financial Ratios and Industry Benchmarks
It is also important that net working capital ratio is not seen in isolation. It should be compared with other financial metrics like return on assets (ROA), inventory turnover, or the quick ratio to gain a comprehensive view of the company’s financial health. Other industry benchmarks should also be paid heed to. For example, some sectors, like retail, thrive on lower working capital ratios due to fast inventory turnover, while others, like manufacturing, may naturally require higher ratios.
How Do You Improve the Working Capital Ratio?
It has been established that the working capital ratio is dependent on the liabilities and assets a company/business currently has.
Identify Strategies for Improving the Working Capital Ratio
Therefore, increasing the variable working capital is quite possible. Here’s
- Decreasing liabilities
When businesses focus on reducing their financial liabilities it increases their cash reserves and helps maintain a healthy cash position. - Reducing Inventory Levels
More inventories often reflect that a business is unable to change its inventory into revenue. Low inventory also shows that the company is struggling to keep up with customer demand. - Shorter operating cycle
A shorter operating cycle reduces the possibility of a later payment. It can thus help in increasing the cash flow. - Accelerating Accounts Receivable Collections
When cash inflows increase through receivable collections, it ensures cash flow.
