6. Liquid ratio, Working capital ratio is the most important ratio

Working capital ratio

  • The working capital ratio tells us how much of the company’s current liabilities will be covered by the company’s short-term assets.
  • This capital ratio is also known as the current ratio.

Formula

This capital ratio is the ratio of currents assets and current liabilities.

working capital ratio formula

Working capital ratio = Current assets / Current liabilities

Both current assets and current liabilities for any company can be found on it’s balance sheet Which you can get by following the instruction given below.

If you do not know about the current assets and current liability, then you can read the post containing part 1 of the liquidity ratio, whose link we have given, please read now

First of all, you have to go to the https://www.moneycotrol.com website, after that you will have to search by entering the name of the company and you will have to click on the option of financial data upwards. you will get an option of a balance sheet as soon as you click. On which you can find current assets and current liability by clicking.

Example

Now you know the working capital ratio, Let’s dive into a quick example. So you can understand clearly how to find this capital ratio.

Let’s consider a hypothetical example, which gives you an idea of how the working capital ratio can provide meaningful example information in your investment analysis.

1– If you are considering Company BHEL as a potential investment, one of the many pieces of information you examine is the liquidity position of the company.

When we check the balance sheet of the company, we get the data of current assets and current liabilities.

  • Current assets = 32,711.18
  • Current liabilities = 22,676.84

When we plug the relevant data into the above formula, we get the working capital ratio of the BHEL company.

Working capital ratio = 32711.18 / 22676.84 = 1.44 or 144%

2. We take an an live example of Infosys date- 01/08/2020

  • Current assets = 54,576.00
  • Current liabilities = 20,856.00

When we plug the relevant data into the above formula, we get this capital ratio of the XYZ company.

Working capital ratio = 54,576.00 / 20,856.00 = 2.61

Analysis

As you can see above how the working capital ratio of BHEL company turned out to be 1.44, now we will try to know what it means.

  1. When the working capital ratio of a company is less than 1, it means that the company cannot meet its short-term liabilities even after selling its short assets. If we see companies of this type for the purpose of investment, then we should stay away from such companies
  2. When the working capital ratio of a company comes to 1, it means that the current assets that the company has, can only meet the short-term liabilities and the company does not have enough money to complete its day to day operations, we should stay away from such companies if we look at the prospect of investment
  3. If the working capital ratio of a company falls between 1.2 to 2, then such companies are considered to be in a very good position and This means that the company will meet its short-term liabilities as well as its day-to-day operations expenses. Such companies give us the opportunity to invest.
  4. If the working capital ratio of a company is more than 2, it means that the company can meet its short-term liabilities, but the company has so much money that it is not able to use it properly. And we should stay away from such companies.

Remark

As you saw in the above example, how we find out the working capital ratio of BHEL and Infosys company, now we will analyze both companies whether it would be right to invest in the companies or not.

  • BHEL’s working capital ratio is 1.44, which is considered a good sign for a company and must be monitored to invest in companies of this type. Because even after completing the short-term liabilities of the company by selling its current assets, some extra money will be saved so that it can run its working operation properly.
  • XYZ company’s working capital ratio is 2.66, which indicates that the company has more cash and is not utilizes properly.

In the next post, we will learn about cash to working capital ratio.

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