Your working capital is the money you need to meet your daily expenses and meet the needs of your business, such as paying for payroll, tools, and supplies. This ratio is particularly valuable in recessionary times since it allows you to assess your company’s financial health objectively.
In what context does this ratio fit, and how can it be used for decision-making? What is the turnover ratio, why does it matter, how can it be calculated, and what can we do with it in this article.
Working capital ratios – what does a healthy one look like?
It is considered healthy for the working capital ratio to be in the range of 1.2 to 2.0. Below 1.0 indicates negative working capital, which is a risky situation. You’d have to sell your current assets to clear your liabilities if you had more liabilities than assets.
Poor cash flow and asset management are often the causes of negative working capital. If your business does not have enough cash to pay its bills, you might have to find another source of business funding.
Do you think you’re golden if you have a ratio over 2.0? It’s not as simple as that. High ratios don’t mean everything is well. If the business uses its assets more than 2.0, that could indicate the business is not maximizing its assets. Take note if you are planning on growing.
Calculating your business’s working capital
- As a general rule, the cost of finished products and debts should be considered when calculating stocks and debts.
- It is unnecessary to include profits when calculating working capital since profits are often not used as working capital and, even if they were, taxes, dividends, etc., would reduce the amount.
- The 100% value of WIP will be taken into account unless stated otherwise. You can also get help with the working capital formula to calculate your working capital easily.
Significance of WCR
Understanding your working capital ratio isn’t a black-and-white affair, as it is with all things accounting. You have to consider your industry, your growth phase, or the impact of seasonality. A person’s ratio will fluctuate as their assets increase, such as if they just made some big purchases or were hired to service a contract with a big client.
It may take a few months for assets to shift, so your ratio may appear misleading for a while. Sometimes, however. The situation of some companies (Amazon, Walmart, etc.) is constant negative. In any case, because it can be turned over quickly and sold to customers before they’ve even paid for the inventory, it’s not a problem.
The fluctuation of accounts receivable is another reason for fluctuating ratios. As long as you keep offering trade credit to stay competitive or deal with late-paying clients, your assets will decline until you get paid. The result will be a skewed metric, yet one that is still realistic.
When you should worry about the working capital ratio
In the short term, inventories are difficult to liquidate, so a company’s working capital turnover ratio can be misleading if its current assets are heavily weighted in favor of them. Inventory turnover ratios below 50% make this problem more obvious. In the same way, it can be problematic for an organization when accounts receivable payment terms are quite long (indicative of unrecognized bad debts).
It is not unusual for ratios to be abnormally low for companies drawing from a credit line because they tend to keep cash balances low and replenish their cash only when it is necessary. It is common to have a ratio of 1:1 or less in these cases, even though credit lines virtually ensure the payment of all liabilities.
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