Working Capital Ratio and the Importance of Working Capital Management

The company needs some amount of liquid assets and capital that would help the company manage its daily activities and this capital is known as working capital. 
If you made a comparison of the company's current assets against its current liabilities, you would arrive at the working capital ratio for the particular company. In order to better understand the working capital ratio let us take a look at the definition of current assets and current liabilities.

Current Assets: Current assets are the short term assets of the company that we are going to consider for the working capital ratio in the form of cash, accounts receivable, inventory, short term investments and pre-paid expenses.

Current liabilities: Current liabilities are the short term liabilities of the company that we are going to consider for the working capital ratio in the form of accounts payable, outstanding expenses, payable taxes and short term loans.

Thus, the working capital ratio is useful in telling us whether the business can support itself with its current assets despite its current liabilities. The mathematical formula to calculate the working capital ratio is:

Working capital ratio = current assets / current liabilities

In order to calculate the working capital ratio we can assume the current assets of a company to be USD 250,000 against
its current liabilities being USD 120,000, therefore the working capital ratio will work out to USD 250,000/ USD 90,000 which is 1.33.

The ideal working capital ratio is between 1.2 and 2.0. In the example above, the working capital ratio is 1.33 which shows a healthy liquidity position. On the other hand, a working capital ratio above 2.0 indicates underutilized assets or bad asset investment. In the case that the working capital ratio is less than 1, the business is in jeopardy and cannot meet its current liabilities. In this case, the company will have to work on their negative working capital ratio with working capital management.

Working capital management is imperative to maintaining a strong working capital ratio. The working capital management will help the working capital ratio which is going to directly pave the way for the financial management of a company. Working capital management for optimum working capital ratio is not difficult and you can easily ensure a good working capital ratio:

1. Working capital ratio can be increased with shorter credit period to clients.

3. Maintaining an optimum level of inventory will ensure good working capital ratio.

4. Holding too much cash also tends to make your working capital ratio suffer.

Investors are very keen on investing in companies with a good working capital ratio. Not only is a good working capital ratio essential for smooth functioning of the company but also contributes to investments.

Sources: http://voices.yahoo.com