The Working capital ratio is calculated under the liquidity ratio with its liquid assets. With the working capital ratio, investors and creditors analyze whether the company is moving towards the way of success or loss.
Before proceeding further, here are some important points which will clarify this topic.
- This ratio is the category of liquidity ratio under financial ratio analysis.
- This ratio helps to find the company’s capability to pay all short-term obligations quickly.
- Working capital should not be taken lightly as it describes the liquidity of the company.
- Positive and negative working capital ratios, both put a big impact on the company’s financial status.
- This ratio indicates how long a company can survive.
- The Ideal ratio of working capital lies between 1.2 to 2.0.
Why is Working Capital calculated?
It is important to calculate this ratio as it shows the company’s ability to pay debts whether the company is worth it or not. The Working Capital Ratio indicates whether the company is financially strong to pay all short-term debts.
This ratio is calculated by the current assets and is divided by current liabilities.
Usually, every company takes a loan to meet its success requirements now whether it is from anyone, from any relative (friends or family), or professional investors ( venture capitalist, banks, or other financial institutions). But after taking money, these creditors also have to pay and if companies do not pay then they will get bankrupt and there will be a negative impact on the company’s goodwill. According to us, no reputed company wants to spoil its goodwill which is made in the market.
Role of Current assets and Current Liabilities to calculate Working Capital Ratio
Without current assets and current liabilities, the company can’t determine the working capital ratio.
If we talk about working capital, it refers to the current assets minus current liabilities. So it must be known from this that it shows how big a hand of current assets and current liabilities would have in finding the working capital ratio.
Now the time has come to tell why current assets and current liabilities are given so much importance to calculate this ratio because currents assets are the assets that contain cash, cash, and cash equivalents, marketable securities that generally needed to convert into cash to cover current liabilities but if the company will pay debts with its current asset so it doesn’t a great thing because by selling assets, if the company is not going to the loss in repaying the loan, then it is not going to profit either. So, the assets and liabilities of the company have to be managed by equal management only when this ratio of the company shows great experience.
Current assets include account receivables, inventory, cash, cash equivalents to pay current liabilities such as account payables.
(Current assets = Current liabilities), shows the ideal ratio of working capital is 1.
It means current assets are equal to current liabilities, so this doesn’t affect the working capital rather, it is constant. It shows that the company sells current assets to pay short-term liabilities.
(Current assets > current liabilities), shows the ideal ratio of working capital is more than 1.
It means current assets are more than current liabilities, so this affects the positive impact on this ratio, it shows that the company is eligible to pay all short-term liabilities on time and the company is going on the right path to get success.
With this ratio impact, it has more chances to increase the company’s growth.
(Current assets < Current liabilities), shows the ideal ratio of working capital is less than 1.
It means that the company is in the worst situation in which it is unable to recover a single debt of the company, it shows that the company is not eligible to pay short-term liabilities on time even anytime and the company is not going on the right path to get success.
With this ratio impact, it has fewer chances to increase the company’s growth.
Changes in working capital ratio disbalance the cash flow statement, balance sheet, sales, revenue of the company. In simple words, it impacts poor or good results on a company’s financial position.
Who analyzes the Working Capital Ratio?
Working Capital Ratio is judged or calculated by the investors and creditors to find out the accurate position of the company because both are the professional financial helpers of the company.
Investors and creditors are the people who have the right to calculate this ratio to analyze the company’s paying loans or debts capacity. Both have the same intention to calculate this ratio, to get money but there is only one difference: investors want to get money regularly as a shareholder but creditors want to get the money that company borrowed from them.