Working capital ratio is a financial calculation designed to measure a company's financial strength in the short term. Also known as the current ratio, this ratio is calculated by taking the sum total of a company's assets and dividing them by the liabilities that the company currently owes. A negative working capital ratio is problematic because it means that if the company was forced to pay off all of its liabilities immediately, it would not be able to do so, nor would it have any money left over for daily operations. The standard for a good ratio depends on the circumstances of the business and the volatility of the industry the business inhabits.
It isn't enough for an investor to know if a company is turning a profit, because that doesn't tell the whole tale. A better measurement of fiscal strength is how much capital a company has to both cover any potential losses and to grow the business through investments. The working capital ratio is a good indicator of such financial strength, and it provides the most immediate picture of the money a company has at hand at the time the ratio is calculated.
As an example, imagine that company A has a total of $1,000 US Dollars (USD) in assets, which can take the form of cash, stocks, inventory, or accounts receivable. This company has also amassed a total of $800 USD worth of liabilities, which usually take the form of accounts payable. By dividing the $1,000 USD by the $800 USD, a working capital ratio of 1.25 is reached.
A company that shows a downward trend in its working capital ratio should throw up a red flag to investors, as this is a sign that the company may not be fiscally sound and may be headed toward bankruptcy. In addition, a company may also analyze its own ratio as a way to spot any efficiency problems it might be having. For example, a company reporting good profits with a low current ratio may not be doing a good enough job of collecting payments.
It's also worth noting that an excessively high working capital ratio is not necessarily a good sign for a company. That could actually mean that the company is not using enough of its excess capital for investment opportunities. Along the same lines, sometimes a low ratio isn't a dire sign, especially for a newer company that may have more of its capital invested than a long-standing company. The standard for a good current ratio also depends on what industry the company serves. Businesses in volatile industries demand a higher amount of capital on hand for sudden drops in sales than do businesses in a more stable industry.
