Working Capital Ratio Explained – Key Insights

While several performance metrics are used to gauge a company’s financial health, working capital ratio remains among the key ones most analysts use. Assessing a company’s working liquidity ratio gives you insights into its short-term financial health and liquidity position. Since this ratio considers current assets and liabilities, it gives investors and creditors insights into the company’s ability to pay for daily operations, make payroll, and keep operations running smoothly. Understanding what operational liquidity ratio is can help entrepreneurs better manage short-term liquidity, sway investor confidence, convey creditworthiness, and seize growth opportunities.

What is the Operations Liquidity Ratio?

A company’s operations liquidity ratio is a ratio of its current assets to its current liabilities. This ratio indicates if the company can pay off its current liabilities with existing assets. It is a measure of the company’s short-term liquidity and financial solvency.

For working capital computations, current assets include assets that can be liquidated into cash within the next twelve months/business cycle. This includes cash and its equivalents, inventory, accounts receivable, marketable securities, short-term investments, etc. Current liabilities include short-term debts, accounts payable, taxes, payroll payments, etc.

Also Read: Working Capital Requirement Calculation- Formula & Ratio

Why Does the Operations Capital Ratio Matter?

The Operations capital ratio is a crucial financial metric that offers valuable insights into a company’s short-term financial health. It measures how well a business can cover its immediate obligations using its current assets. It provides a snapshot of its liquidity and operational efficiency.

• Assessment of liquidity: This ratio serves as a vital indicator of financial stability for businesses. A healthy operations capital ratio suggests that a company can comfortably meet its short-term debts, while having enough resources to fund day-to-day operations. This balance is essential for smooth business functioning and growth. Having enough operational liquidity would mean that the business is in a solid position to meet its short term obligations which would require cash.
• Operational efficiency: The operations capital ratio reflects a company’s operational efficiency. It shows how well a business manages its inventory, collects payments from customers, and pays its suppliers. A well-managed ratio indicates that the company is adept at converting its products into cash and maintaining a healthy cash flow.
• Creditworthiness and investor confidence: Lenders and investors pay close attention to the operations liquidity ratio when assessing a company’s financial soundness. A strong ratio can open doors to better financing options and attract potential investors. This demonstrates the company’s ability to manage its resources effectively and meet its financial commitments. 
• Risk management: From a risk management perspective, monitoring changes in the operational liquidity ratio over time can help businesses identify potential financial troubles before they escalate. A declining ratio might signal increasing financial stress. It prompts management to take corrective actions quickly. 

It is worth noting that while a higher ratio generally indicates better financial health, an excessively high ratio might suggest otherwise. It may indicate that the company is not utilizing its assets efficiently. Striking the right balance is key to optimizing working liquidity and ensuring sustainable business growth.

In essence, the operations capital is more than just a number. Working liquidity analysis proves to be a powerful tool that helps businesses, investors, and lenders gauge a company’s financial stability, operational efficiency, and growth potential. By keeping a close eye on this ratio, companies can make informed decisions to maintain their financial health and navigate the challenges of the business world more effectively.

How to Calculate Working Capital Ratio?

Now that you know what working cash ratio is, it’s time to focus on the formula used for its calculation:

Working Capital Ratio = Current Assets / Current Liabilities

Let’s understand this formula with an example. Say a textile company, ABC, has current assets worth Rs. 2,50,000 and current liabilities worth Rs. 1,75,000. In this case, the working cash ratio for ABC will be:

Working Cash Ratio = 2,50,000/1,75,000

Working Cash Ratio = 1.43

Interpreting Working Capital Ratios

Correctly interpreting a working cash ratio is essential to understand the company’s financial health and fine-tuning strategies. Working cash ratios can be interpreted as follows:

1. Low Working liquidity Ratio:

A working liquidity ratio below 1 suggests a negative cash flow since the company’s current liabilities outweigh its current assets. In other words, the company cannot cover its short-term obligations, pay creditors, and meet operational costs with its current asset reserves. A low working liquidity ratio may be caused by several factors like: decreasing sales, issues with accounts receivable, and inventory mismanagement. A consistently declining working liquidity ratio can indicate serious financial troubles for the company.

Understanding Low Working liquidity Using an Example:

Let’s take an example of an ice cream shop in a beach town that faces severe cash flow issues during the winter months. In February, their current assets (including stored ingredients and minimal cash reserves) total $15,000. Their current liabilities (including equipment, lease, and staff wages) reach $25,000. According to the working liquidity formula, this creates a working liquidity ratio of 0.6 (15,000/25,000).

The shop is unable to cover ongoing expenses with its available assets. This may force the owner to consider temporary closure or seek additional financing to survive until the tourist season begins. 

2. High Operations liquidity Ratio:

An operations liquidity ratio above one is considered positive. This means that the company’s current assets can cover its current liabilities. However, an operations liquidity ratio above 2 is not ideal either. Extremely high ratios indicate that the company is hoarding cash and not utilizing its assets to generate growth.

Understanding High Working liquidity Using an Example:

Let’s take the example of a medium-sized manufacturing company who have accumulated excessive inventory due to overproduction and slower-than-expected sales. Their current assets, including this large inventory and accounts receivable, total $8 million. While their current liabilities are $3 million. This creates an operations liquidity ratio of 2.67 (8,000,000/3,000,000).

While this manufacturing company easily meets its short-term obligations, the high ratio indicates inefficient asset management. The company is tying up too much capital in unsold inventory, potentially leading to storage issues, increased carrying costs, and the risk of inventory obsolescence. The company would benefit from better demand forecasting and lean inventory management practices to optimize its working cash.

What is a Good Operations Liquidity Ratio?

Most financial analysts believe a good operations liquidity ratio falls between 1.5-2. That said, a company’s ideal operations liquidity ratio can vary depending on several factors, including the industry in question, whether the company is in a growth phase, and how established it is. Comparing a company’s ratio with those of other similar companies in the same industry helps analysts understand this performance metric holistically.

Ways to Improve Working Cash Ratio

You can improve the working cash ratio by increasing/speeding up the cash inflow into your business or decreasing/speeding down the cash outflow. Here are a few ways you can boost the working cash ratio for your company:

1. Speed-Up Accounts Receivable:

Streamline the accounts receivable side to ensure early cash inflows. Incentivise early payments by offering early payment benefits and discounts to customers. A shorter cash conversion cycle would mean that the business is able to realize the receivables quickly, which indicates that there is ample demand for the products, and it would really help the business in accumulating more operational capital which is beneficial for the business in both short and long term.

2. Negotiate Better Supplier Payment Terms:

Negotiate with your suppliers to get better pricing and payment terms on your orders. From securing discounts on prompt payments to extending the amount of time you have to pay debts, try negotiating the accounts payable side of the equation as well. By securing favourable terms from the suppliers, the management would in a better position to optimize the operations capital of the business.

3. Avoid Fixed Asset Financing with Working Capital:

Opt for a long-term business loan instead to purchase assets like machinery or other equipment. By using your operational liquidity to fund larger expenses, the management may end up using a big chunk of their working cash, which may result in shortage of funds to operate the business, or think of expansionary plans. By taking a loan for funding these asset expanses, the management would be in a better position to pay off the expense while not facing a shortage of funds for their operations.

4. Cut Unnecessary Expenses:

Eliminate unnecessary short-term liabilities. Assess your operational budget and look for cost-saving avenues to lower your current liabilities. It is essential for any business to be mindful of the expenses, by operating on a lean expense management approach the business can save up funds which would be beneficial for their operations, and can even help fund their long term goals, or expansionary plans.

5. Optimize Inventory Management:

Implement just-in-time inventory practices to reduce excess stock. Use inventory management software to maintain optimal stock levels which can prevent both overstocking and stockouts.  Optimum inventory management would ensure that the company’s capital is not tied up more than required, it would help in avoiding any dead stock, or stock piling and help businesses operate on an efficient model.

6. Lease Instead of Buy:

Consider leasing equipment or vehicles instead of purchasing them outright. This can help preserve cash and improve the operations liquidity ratio by reducing large upfront expenses. By leasing the business would be able to save on a lot of costs. Costs associated with the price consideration of the space, costs to make the space fit for use, stamp duty charges, taxes, etc.

7. Increase Sales:

Focus on boosting revenue through targeted marketing campaigns, upselling to existing customers, or expanding into new markets. Higher sales can increase current assets more quickly than current liabilities. Any business can benefit from increased sales, it not only helps with increased profitability, but having more cash flow can help the business have a better operational liquidity.

8. Refinance Short-Term Debt:

Look into options for converting short-term liabilities into long-term debt. This can improve the operations liquidity ratio by reducing current liabilities. By this conversion, the company would not have the short term liabilities to pay for, this would free up operational liquidity which could be used for other purposes that can help with operational efficiency and increased profitability for the business.

9. Implement Efficient Cash Management:

Use cash management techniques such as cash pooling or sweeping to maximize the utility of available cash across different accounts or subsidiaries. Having an efficient treasury management, will help the business ensure that their cash reserves are able to generate returns while lying idle in the bank account. As business bank accounts (Current accounts) do not earn interest rates on the funds maintained in as bank balance, an efficient cash management policy can help maximize returns essentially increasing profitability of the business.

10. Use Technology for Efficiency:

Implement automation and digital tools in accounting and operations to reduce processing times, minimize errors, and speed up cash flow cycles. Use enterprise resource planning (ERP) systems to help manage inventory, accounts payable, and receivable more effectively. This can ultimately improve cash flow management.and help businesses generate more returns on the capital employed.

11. Sell Underutilized Assets:

Identify and sell any non-essential or underutilized assets. This can provide an immediate cash boost and improve the operational liquidity ratio. Since these assets being unutilized or underutilized are serving little to no purpose, it could help dispose of such assets as it can help the company work in a more agile fashion, while utilizing the money made by selling the asset in a more productive way.

12. Streamline Procurement:

Review and optimize the procurement process to reduce lead times and costs. Implementing a strategic sourcing approach can help identify cost-saving opportunities and enhance supplier negotiations. By streamlining the procurement, the business can save costs associated with getting the products used to manufacture or supply the products or services. This saved cost ultimately doubles down as it helps the business utilize the saved costs elsewhere to enhance efficiency of the processes and increase profitability.

13. Boost Customer Loyalty:

Implement customer retention strategies such as loyalty programs, personalized marketing, and excellent customer service. Retaining customers can lead to consistent revenue streams and improved cash flow. You can also encourage faster payment from customers by offering small discounts for early payment. This can speed up the cash inflow of your business. 

By taking steps to boost customer loyalty, the business can expect an uptrend in the revenue realization which essentially means more operational liquidity to play around with, which can utilized to enhance processes and improve profitability.

14. Enhance Workforce Efficiency:

Invest in training programs to improve employee productivity and efficiency. A skilled workforce can contribute to better inventory management, faster order processing, and improved customer service, all of which can positively impact operational liquidity.

15. Adopt Lean Practices:

Incorporate lean management principles to eliminate waste and inefficiencies in operations. Lean practices can help reduce excess inventory, lower production costs, and improve overall efficiency. Increased efficiency can help any business massively, since there will be less wasted resources, and the management would be able to derive maximum value from every penny spent on operations. This has a massive effect on the operational capital of the business, as lean practices help increase working liquidity exponentially.

16. Plan for Seasonal Fluctuations:

Develop strategies to manage cash flow during seasonal variations in demand. This can include securing short-term financing, adjusting inventory levels, and planning marketing campaigns to boost off-season sales. Not only this, seasonal fluctuations can be both positive and negative. In case of off season, where the business sees lower demand than usual, working liquidity can help businesses operate more efficiently, and in case of increased demand during peak seasons, working liquidity can help manage the surge in demand more efficiently allowing the business to grow.

17. Build Financial Buffers:

Create financial reserves to cushion against unexpected expenses or economic downturns. A strong financial buffer can help maintain a healthy working liquidity ratio during challenging times.

Building financial buffers can be a boon to the company. As buffers give the headspace to the entrepreneurs to take expansionary measures while not worrying about the expenses related to the day to day activities of the business. These financial buffers also allow the business to sail through the seasonal demand drought, while not having an impact on the business’ ability to fulfill its short term liabilities. 

18. Utilize Tax Breaks and Incentives:

Explore available tax incentives and breaks to reduce tax liabilities and improve cash flow. Working with a tax advisor can help identify opportunities for tax savings. 

Every penny saved can be used towards a more productive means, with plenty of exemptions allowed while filing for taxes, the entrepreneurs can take advantage of these tax breaks by using efficient account practices, and use the money saved towards making the business more efficiently sound.

Correlating Operational Liquidity Ratio with Capital Turnover Ratio

Having a high operational liquidity ratio isn’t enough. Efficiently managed companies should also have a positive capital turnover ratio. The capital turnover ratio demonstrates the relationship between the company’s turnover (revenue) and operational liquidity. It indicates how effectively a business generates sales revenue from every Rupee of working capital available to it. In other words, the capital turnover ratio shows how effectively the company is using available assets to generate sales.

A company’s high operations capital ratio and low capital turnover ratio signal inefficiencies. It could mean the company has underutilized assets, decreased sales, operational challenges, or a conservative approach to liquidity management. Alternatively, a company’s high operations capital ratio and high capital turnover ratios indicate ample short-term assets and efficient use of these assets to generate sales. In other words, this suggests efficient liquidity management that translates to sales and revenue.

Contextualizing Operations Capital Ratios

While understanding what an operations capital ratio is remains essential, it can be misleading if not properly contextualized. For instance, fast-growing companies that are investing in growth with external credit lines may have a low working liquidity ratio. However, they will likely be in a stronger position when the growth pays off. Similarly, a company’s poor working liquidity ratio may be a result of very high inventory turnover rates and short cash conversion cycles. Hence, working liquidity ratios have to be interpreted within a contextual framework like all other performance metrics.

Frequently Asked Questions

What is an Ideal Working Capital Ratio?

Analysts say a working capital ratio between 1.5 and 2 is ideal. However, this can differ based on sector and business growth stages.

Why is a Working Liquidity Ratio Below One Bad?

A working liquidity ratio below 1 indicates that the company’s current liabilities exceed its current assets. This means that the company cannot meet its short-term obligations without external funding. A low working liquidity ratio indicates liquidity issues, management inefficiency, and future financial troubles for the company.

Why is Working Capital Ratio Important?

A company’s working liquidity ratio is an important performance metric since it summarizes its liquidity position and working liquidity management efficiency. A company with a good working liquidity ratio can manage current liabilities efficiently without upsetting its cash flow or resorting to external financing. Alternatively, one with a low ratio is characterized by inefficient working liquidity management.