Day 2 of Fundamental Investing
Continuing with our Liquidity Ratios, today we will be understanding another liquidity ratio used quite commonly.
Its called the Working Captial Ratio/ Current ratio.
What is it?
-The working capital ratio, also called the current ratio, is a liquidity ratio that measures a firm’s ability to pay off its current liabilities with current assets. The working capital ratio is important to creditors because it shows the liquidity of the company.
Current liabilities are best paid with current assets like cash, cash equivalents, and marketable securities because these assets can be converted into cash much quicker than fixed assets.
The faster the assets can be converted into cash, the more likely the company will have the cash in time to pay its debts. The reason this ratio is called the working capital ratio comes from the working capital calculation. When current assets exceed current liabilities, the firm has enough capital to run its day-to-day operations. In other words, it has even capital to work. The working capital ratio transforms the working capital calculation into a comparison between current assets and current liabilities.
How to calculate it?
Here's an image for the same:
What's its significance?
-Since the working capital ratio measures current assets as a percentage of current liabilities, it would only make sense that a higher ratio is more favourable. A WCR of 1 indicates the current assets equal to current liabilities.
A ratio of 1 is usually considered the middle ground. It’s not risky, but it is also not very safe. This means that the firm would have to sell all of its current assets in order to pay off its current liabilities. A ratio less than 1 is considered risky by creditors and investors because it shows the company isn’t running efficiently and can’t cover its current debt properly.
A ratio less than 1 is always a bad thing and is often referred to as negative working capital. On the other hand, a ratio above 1 shows outsiders that the company can pay all of its current liabilities and still have current assets leftover or positive working capital.
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