Working capital ratio
Strategic perspective
Financial perspective
Key performance question this indicator helps to answer
How well are we managing our cash flow?
Why is this indicator important?
We discussed the importance of cash flow in our previous KPI. The simple truth is that in order to build the business an organisation needs a healthy supply of cash. Without readily available cash an organisation will struggle to grow and will equally be challenged to fund day-to-day operational activities. To understand the cash position, organisational leaders will typically use the working capital ratio as another key cash-flow measure.
In essence, working capital (also referred to as current position) is a measure of current assets minus current liabilities and therefore measures how much in liquid assets a company has available to build and maintain its business. To make the numbers comparable between companies, we create the working capital ratio, which takes the current assets and divides them by the current liabilities to arrive at a ratio. Both the working capital and the ratio can be positive or negative, depending on how much debt the company is carrying. The ratio is positive when it is above 1 or negative when it is below 1.
The working capital ratio indicates whether a company has enough short-term assets to cover its short-term debt. In general, companies that have a lot of working capital and therefore a positive working capital ratio will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth: such companies might be forced to borrow from the debt markets (which can be expensive), which over the longer term might further weaken the cash position and so put further pressure on an organisation’s ability to grow or fund operations.
How do I measure it?
Data collection method
Collecting the data for the working capital ratio begins by determining current assets. Current assets are comprised of cash, marketable securities, accounts receivable and current inventory. Sum the total value of each of the above to arrive at the current assets.
The next step is to collect the data relating to current liabilities, which include accounts payable, accrued expenses, notes payable, short-term debt (such as bank loans and lines of credit) and the portion of long-term debt that is classified as current (that is, payable within 12 months). Sum all of these accounts to arrive at the current liabilities figure.
Formula
For the actual numeric value of your working capital, simply take the total of the current liabilities and subtract these from the current assets. The result will be the working capital:
The working capital ratio is calculated by dividing the current assets by the current liabilities:
Frequency
Organisations typically measure their working capital once every quarter.
Source of the data
These data can be extracted from the accounting data and balance sheet.
Cost/effort in collecting the data
The cost for collecting this KPI is very low as all the data are readily available from the balance sheet.
Target setting/benchmarks
The benchmarks for working capital ratios are industry-specific. As a very rough ball-park benchmark, most believe that a ratio of between 1.2 and 2.0 is sufficient. For more detailed industry-specific data check out the working capital surveys by REL Consultancy, which has since the later 1990s been conducting a Working Capital Survey of 1,000 companies in both the US and Europe. The most recent year’s survey results can be downloaded for free from the company website and include:
- key trends in working capital performance by company and industry (data from 2004 onwards);
- how an organisation’s working capital performance compares with peers and top performers;
- metrics for measuring and managing working capital performance.
Example
Consider the following example. In calculating current assets an organisation finds that it has $200,000 in cash, $100,000 in securities, $20,000 in accounts receivable and $60,000 in inventory.
On the current liabilities side, the company has $120,000 in accounts payable, $20,000 in accrued expenses and $40,000 in current debt.
The current assets are $200,000 + $10,000 + $20,000 + $60,000 or $380,000. The current liabilities are $120,000 + $20,000 + $40,000 or $180,000.
Take the current assets of $380,000 and subtract the current liabilities of $180,000 to arrive at the working capital of $200,000:
$380,000 − $180,000 = $200,000
and a working capital ratio of:
Tips/warnings
Working capital is often used as a barometer to measure an organisation’s overall health and liquidity. As a result, it is a measure that is followed very closely by investors (and especially so as investors assess an organisation’s ability to weather the severe global economic downturn). Being in a negative working capital position often makes an organisation unattractive to potential investors, so it can negatively impact the stock price and therefore damage shareholder value metrics.
All in all, working capital should always be at the forefront of senior executives’ minds.
References
Working Capital Newsletter: www.relconsultancy.com
Working Capital Survey: www.relconsultancy.com