Working Capital Ratio

The working capital ratio is the same as the current ratio. It is the relative proportion of an entity's
current assets to its current liabilities, and is intended to show the ability of a business to pay for its
current liabilities with its current assets. A working capital ratio of less than 1.0 is a strong indicator
that there will be liquidity problems in the future, while a ratio in the vicinity of 2.0 is considered to
represent good short-term liquidity.

To calculate the working capital ratio, divide all current assets by all current liabilities. The formula is:
Current Assets
Current Liabilities
Working Capital Ratio Example
A potential acquirer is interested in the current financial health of the Beemer Designs retail chain,
which sells add-on products for BMW automobiles. She obtains the following information about the
company for the past three years:

Current assets
Current liabilities
Working capital ratio

Year 1
$4,000,000
$2,000,000
2:1

Year 2
$8,200,000
$4,825,000
1.7:1

Year 3
$11,700,000
$9,000,000
1.3:1

The rapid increase in the amount of current assets indicates that the retail chain has probably gone
through a rapid expansion over the past few years and added both receivables and inventory. The
sudden jump in current liabilities in the last year is particularly disturbing, and is indicative of the
company suddenly being unable to pay its accounts payable, which have correspondingly ballooned.
The acquirer elects to greatly reduce her offer for the company, in light of the likely prospect of an
additional cash infusion in order to bring its operations onto an even keel.
Problems with the Working Capital Ratio
The working capital ratio can be misleading if a companys current assets are heavily weighted in favor
of inventories, since this current asset can be difficult to liquidate in the short term. This problem is
most obvious if there is a low inventory turnover ratio. A similar problem can arise if accounts
receivable payment terms are quite lengthy (which may be indicative of unrecognized bad debts).
The working capital ratio will look abnormally low for those entities that are drawing down cash from a
line of credit, since they will tend to keep cash balances at a minimum, and only replenish their cash
when it is absolutely required to pay for liabilities. In these cases, a working capital ratio of 1:1 or
less is common, even though the presence of the line of credit makes it very unlikely that there will be
a problem with the payment of liabilities.

Sales to Working Capital Ratio

It usually takes a certain amount of invested cash to maintain sales. There must be an investment in
accounts receivable and inventory, against which accounts payable are offset. Thus, there is typically a
ratio of working capital to sales that remains relatively constant in a business, even as sales levels
change.

This relationship can be measured with the sales to working capital ratio, which should be reported on
a trend line to more easily spot spikes or dips. A spike in the ratio could be caused by a decision to
grant more credit to customers in order to encourage more sales, while a dip could signal the reverse.
A spike might also be triggered by a decision to keep more inventory on hand in order to more easily
fulfill customer orders. Such a trend line is an excellent feedback mechanism for showing management
the results of its decisions related to working capital.
The sales to working capital ratio is calculated by dividing annualized net sales by average working
capital. The formula is:
Annualized net sales
Accounts receivable + Inventory - Accounts payable
Management should be cognizant of the problems that can arise if it attempts to alter the outcome of
this ratio. For example, tightening credit reduces sales, shrinking inventory may also reduce sales, and
lengthening payment terms to suppliers can lead to strained relations with them.
Example of the Sales to Working Capital Ratio
A credit analyst is reviewing the sales to working capital ratio of Milford Sound, which has applied for
credit. Milford has been adjusting its inventory levels over the past few quarters, with the intent of
doubling inventory turnover from its current level. The result is shown in the following table:

Revenue
Accounts Receivable
Inventory
Accounts Payable
Total Working Capital
Sales to Working Capital Ratio

Quarter 1
$640,000
214,000
1,280,000
106,000
1,388,000
1.8:1

Quarter 2
$620,000
206,000
640,000
104,000
742,000
3.3:1

Quarter 3
$580,000
194,000
640,000
96,000
738,000
3.1:1

Quarter 4
$460,000
186,000
640,000
94,000
732,000
3.1:1

The table includes a quarterly ratio calculation that is based on annualized sales. The table reveals
that Milford achieved its goal of reducing inventory, but at the cost of a significant sales reduction,
probably caused by customers turning to competitors who offered a larger selection of inventory.

Working Capital Productivity

The working capital productivity measurement compares sales to working capital. The intent is to
measure whether a business has invested in a sufficient amount of working capital to support its sales.
From a financing perspective, management wants to maintain low working capital levels in order to
keep from having to raise more cash to operate the business. This can be achieved by such techniques
as issuing less credit to customers, implementing just-in-time systems to avoid investing in inventory,
and lengthening payment terms to suppliers.

Conversely, if the ratio indicates that a business has a large amount of receivables and inventory, this
means that the business is investing too much capital in return for the amount of sales that it is
generating.

Ideally, there is a midway point in this ratio that represents a reasonable usage of working capital to
support the needs of a business. It is possible to drive for an excessively low proportion of working
capital to sales, which can result in inventory stockouts and annoyed customers.
To decide whether the working capital productivity ratio is reasonable, compare a company's results to
those of competitors or benchmark businesses.
To derive working capital productivity, divide annual revenues by the total amount of working capital.
The formula is:
Annual revenues
Total working capital
For example, a lender is concerned that Hubble Corporation does not have sufficient financing to
support its sales. The lender obtains Hubble's financial statements, which contain the following
information:
Annual revenues
Cash
Accounts receivable
Inventory
Accounts payable

$7,800,000
$200,000
$800,000
$2,000,000
$400,000

With this information, the lender derives the working capital productivity measurement as follows:
$7,800,000 Annual revenues
$200,000 Cash + $800,000 Receivables + $2,000,000 Inventory - $400,000 Payables
= 3:1 Working capital productivity
This ratio is lower than the industry average of 4:1, which indicates poor management of the
company's receivables and inventory. The lender should investigate further to see if the receivable and
inventory figures may contain large amounts of obsolete items.
When using this measurement, consider including annualized quarterly sales in order to gain a better
short-term understanding of the relationship between working capital and sales. Also, the
measurement can be misleading if calculated during a seasonal spike in sales, since the formula will
match high sales with a depleted inventory level to produce an unusually high ratio.

Working Capital Turnover Ratio

The working capital turnover ratio measures how well a company is utilizing its working capital to
support a given level of sales. Working capital is current assets minus current liabilities. A high
turnover ratio indicates that management is being extremely efficient in using a firm's short-term
assets and liabilities to support sales. Conversely, a low ratio indicates that a business is investing in
too many accounts receivable and inventory assets to support its sales, which could eventually lead to
an excessive amount of bad debts and obsolete inventory.

Working Capital Turnover Formula

To calculate the ratio, divide net sales by working capital (which is current assets minus current
liabilities). The calculation is usually made on an annual or trailing 12-month basis, and uses the
average working capital during that period. The calculation is:
Net sales
(Beginning working capital + Ending working capital) / 2
Working Capital Turnover Example
ABC Company has $12,000,000 of net sales over the past twelve months, and average working capital
during that period of $2,000,000. The calculation of its working capital turnover ratio is:
$12,000,000 Net sales
$2,000,000 Average working capital
= 6.0 Working capital turnover ratio
Issues with the Measurement
An extremely high working capital turnover ratio can indicate that a company does not have enough
capital to support it sales growth; collapse of the company may be imminent. This is a particularly
strong indicator when the accounts payable component of working capital is very high, since it
indicates that management cannot pay its bills as they come due for payment.
An excessively high turnover ratio can be spotted by comparing the ratio for a particular business to
those reported elsewhere in its industry, to see if the business is reporting outlier results.
Similar Terms
The working capital turnover ratio is also known as net sales to working capital.