Working Capital Ratio
Companies can use a working capital ratio to decide the short-term success of their business. Using this calculation is a good method for understanding the implications of expenditures and income.How to calculate the WC ratio?
The working capital ratio can be calculated using the simple formula of:Current ratio = current assets / current liabilitiesWhere assets include cash, stock, and bill receivable and liabilities include bills payable and outstanding payments.
In profitable business, the ratio will be over 1.0 meaning the assets are greater than liabilities. In a business, whose liabilities are greater than the assets, the ratio will be below 1.0. A continued ratio below 1.0 will lead to long-term losses and eventually could cause the business to fail.
Why is it so important?
A low ratio does not automatically reflect business failure, but it should be a warning that changes may need to be made to existing company strategy. General ups and downs in the market and business needs can result in a low number, and this should be considered when analyzing results.
It is important to note that the WC ratio is for short-term analysis and the long-term success of a business is reliant on additional factors. The appropriate interpretation of this ratio can help expand a business or fix over expenditure.
When the ratio reaches 2.0, the current assets far exceed liabilities. If a business reaches this ratio, more of the asset can be invested for expansion. If no action is taken, the profits are not being used to their fullest potential, and the business will not move forward.
There are a number of other important considerations regarding the ratio that allows for variations in the number. For example, a company with an established reputation can temporarily sustain a low ratio with the expectation that the good name of the company will help improve profits in the long-term.
Industries that rely on monthly payments may see their ratio affected as the expenditures are greater up front and the income generated is delayed. This needs to be considered when a specific calculation is especially low or high.
What does the ratio show?
The working capital ratio is an indication of current business success. Long-term monitoring of the value can be used to see the changes in success throughout the year. It is useful for members of the business to be aware of the value to be more aware of the financial status of the business.
Large companies generally have a specific team to monitor financial issues, while small business and entrepreneurs can make use of this simple formula to understand the progress and development of the business. An unfavorable ratio may mean that certain downsizing ought to occur or a favorable ratio can allow for expansion.
Being aware of the working capital ratio is necessary for the growth and improvement of a company. The stated essential elements in a business include "capital, equipment, labor, and material" and these will be taken into account in the liabilities. It is necessary that payments and investment returns exceed this amount.
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