Liquidity refers to how easily a company can turn assets into cash to pay off short-term liabilities. The working capital ratio can be useful for measuring liquidity.
Working capital is the difference between a firm’s current assets and current liabilities. It represents the company’s ability to pay off its current liabilities with its current assets.
The working capital ratio, like working capital, compares current assets to current liabilities and is a metric used to measure liquidity. The working capital ratio is calculated by dividing current assets by current liabilities.
Let’s say Company ABC has $100 million in current assets and $50 million in current liabilities. The working capital ratio is 2 ($100 million / $50 million). This is an indicator of healthy short-term liquidity. However, if two similar companies have ratios of 2, but one of them has more cash in its current assets, that firm will be able to pay off its debts faster than the other.
A working capital ratio of 1 may mean that a company may have liquidity problems and be unable to pay its short-term liabilities. However, the problem may be temporary and improve later.
A working capital ratio of 2 or higher may indicate healthy liquidity and the ability to pay short-term liabilities. On the other hand, it can also indicate a company that has too many short-term assets (such as cash), some of which could be better used to invest in the company or pay dividends to shareholders.
It can be a difficult task to determine the correct category for the huge number of assets and liabilities on the corporate balance sheet in order to decipher the firm’s overall ability to meet its short-term obligations.