In financial analysis, working capital ratio or current ratio is used to measure liquidity position of a company; it is calculated by dividing current assets by current liabilities. The formula to calculate working capital ratio is as under:
Working capital ratio = Current assets/Current Liabilities
Suppose, you have $1,000 and want to invest in a company Z, which has $500 in cash, $2,500 of receivables in current assets and $3,200 in current liabilities. In order to evaluate the liquidity position, a working capital ratio can be calculated as under:
Working capital ratio = Current assets / Current Liabilities
Working capital ratio = Current assets (Cash + Receivables) / Current Liabilities = 3,000/3,200 = 0.937
The working capital ratio of 0.937 or below 1 means that company is not in good liquidity position because it has more current liabilities of $3,200 than its current assets of $3,000, resulting in difficulties to pay back short-term liabilities. Under those circumstances, it will not be a rational decision to invest in that company because there is no sign that company will pay a return on investment in future.
Point to consider while calculation and analysis
Although this ratio provides a measure to gauge liquidity and reasonable confidence to invest however there are some limitations like:
- Increased current assets may not be a good sign, for example, there might be extra piles of purchase inventory which should not have purchased too early or without planning, resulting in utilizing cash without considering efficiency and effectiveness. So one should also judge management actions despite just measuring liquidity position.
- Nature of business operation across the industry changes substantially and this ratio does not help to compare two different business across the industry rather just help to compare business within the same industry.
- As this ratio is used to measure liquidity position but it does not provide a precise picture as provided by other liquidity ratios like quick ratio in which all those assets are excluded from current assets which are not readily available to convert into cash.