A company's working capital ratio can be too high in that an excessively high ratio might indicate operational inefficiency. A high ratio can mean a company is leaving a large amount of assets sit idle, instead of investing those assets to grow and expand its business.
Understanding Working Capital
A company's working capital position indicates how financially sound the company is and how efficiently it is being managed. The working capital ratio measures liquidity and is often used in conjunction with the current ratio to gauge a company's ability to handle short-term obligations.
The working capital ratio is calculated by dividing current assets by current liabilities. For this calculation, current assets are assets a company reasonably expects to be converted into cash within one year or one business cycle. This includes items such as inventory, accounts receivables, and cash or cash equivalents. Current liabilities include accounts payables, leases, income taxes and payable dividends.
An examination of working capital takes into account key elements of a company's basic business operations, such as inventory, accounts receivables and accounts payables. How well a company manages each element is ultimately reflected in the company's working capital ratio. Exceptionally efficient or inefficient handling of any of these basic operations impacts a company's working capital position.
Assessing Working Capital Management
A working capital ratio of 1.0 indicates a company's readily available financial assets exactly match its current short-term liabilities. While a ratio of 1.0 indicates a company should be able to adequately meet its short-term obligations, analysts prefer to see a ratio higher than 1.0, indicating the company has excess working capital left over beyond just being able to pay its expenses. Excess working capital provides some cash cushion against unexpected expenses and can be reinvested in the company's growth. A ratio below 1.0 is unfavorable, as it indicates the company's current assets are not sufficient to cover near-term obligations.
A working capital ratio somewhere between 1.2 and 2.0 is commonly considered a positive indication of adequate liquidity and good overall financial health. However, a ratio higher than 2.0 may be interpreted negatively. An excessively high ratio suggests the company is letting excess cash and other assets just sit idle, rather than actively investing its available capital in expanding business. This indicates poor financial management and lost business opportunities.
