How to Use the Working Capital and Current Ratio Liquidity Metrics
Companies use the working capital metric to tell them exactly what their net value is in the short run. If you paid off all your short-term debts, what would the value of your remaining short-term assets be? For example, if you paid off your credit cards, would you have any money left in your bank account?
Here’s what the working capital metric looks like:
Current assets – Current liabilities = Working capital
To put this equation to use, follow these steps:
Find current assets and current liabilities on the balance sheet in the assets and liabilities sections (go figure!).
Subtract current liabilities from current assets to get the working capital.
If a company has more short-term assets than short-term liabilities, then the company’s working capital is a positive number. Companies like to see positive working capital because it indicates that they’re going to be able to pay off their debts for at least the next year or so.
Another way to look at a company’s liquidity for the next 12 months is by using the current ratio. This ratio calculates the number of times a company could pay off its current liabilities, using its current assets. Here’s what the ratio looks like:
And here’s how to use it:
Find current assets and current liabilities on the balance sheet.
Divide current assets by current liabilities to get the current ratio.
So if a company had twice as many current assets as it had current liabilities, it would have a current ratio equal to 2.0. If a company had half as many current assets as it had current liabilities, then its current ratio would be 0.5.
Because the current ratio includes inventories in addition to other forms of current assets, a low current ratio can indicate that a company is either at risk or very good at managing a low inventory (which is good for keeping costs down). In other words, you have to have some context to make this ratio really useful.