Current Ratio vs. Working Capital: What Are the Differences?

The working capital ratio is calculated simply by dividing total current assets by total current liabilities. For that reason, it can also be called the current ratio. It is a measure of liquidity, meaning the business’s ability to meet its payment obligations as they fall due.

Working Capital, Current Ratio

What is current ratio?

Current ratio measures a companys responsibility when making payments, big or small, over the course of a year. Current ratio exists to inform potential and current investors of a companys ability to maintain a positive liquidity ratio. An acceptable current ratio is always either equal to or a little higher than the industry average. Current ratios that fall below the industry average may show investors the company is at a higher risk of default or general financial instability.

If a company has a current ratio that is too high, or very high compared to similar peer businesses, investors may believe the company is not spending its assets efficiently. A proper current ratio stays as close to the industry standard as possible to maintain good business.

What is working capital?

Working capital is the metric that represents how liquefiable a company is currently. Calculating working capital involves taking the current assets of a business and subtracting the current liabilities. If the current assets are less than the current liabilities, the business has a capital deficiency.

A business that has more assets than liquidity cannot readily convert all assets into cash, making it undesirable in terms of versatility in an ever-changing business market. Investors may look for businesses with a positive working capital that ensures the business can continue operations in the event of short-term and long-term debts, ongoing operating expenses and unexpected business-related challenges.

Why is it important to know your current ratio?

Because a current ratio is public knowledge to both investors and the members of a business, being aware of your current ratio helps see your business from an investors point of view. If a potential investor observes a business has a poor current ratio, it may lead them to believe the business sometimes leaves short-term debt uncovered. Current ratio awareness also informs the business of a comparison option that can mark progress alongside other competing businesses.

What is the difference between current ratio and working capital?

The difference between current ratio and working capital is current ratio is the proportion of current assets divided by the amount of current liabilities. The formula for finding current ratio is:

Current assets / current liabilities = Current ratio

Working capital is the amount remaining after we subtract the current liabilities from the current assets. The current ratio is a ratio rather than an amount. The working capital is a resulting amount. The formula used to find working capital is:

Current assets – Current liabilities = Working capital

Why is it important to know your working capital?

Businesses need to know their working capital in order to be financially aware and being aware of how a business is doing financially can help support its short-term goals, such as paying bills and liability acknowledgment. They can ensure that they can save reserves for unpredictable or unforeseen challenges regarding the economy and business environment.

What factors impact working capital?

Multiple factors can impact a business working capital, some of which are liable to change. Others are permanent factors you can take into consideration when attempting to adjust your working capital. Factors that may affect working capital include:

Size

One of the largest effects on a business working capital is its size. The nature of the business may also affect working capital significantly, in both volume and content. Larger businesses may not require as much money to become invested in fixed assets. However, large companies may also require a sizable amount of funds to maintain an acceptable working capital. Retail stores, alternatively, must maintain a high amount of assets for the needs of their customers and business.

Cycle

If a business has one season that is busier than another, that business would require higher working capital. During low seasons, no matter the business, there is a period that requires less working capital than the business standard. This is because more sales and collection require more working capital to maintain during the inevitable waiting periods that exist between them. Increased wages and raw materials because of a business cycle may also affect the required working capital of a business.

Efficiency

Different elements of business efficiency affect the required working capital in differing ways. The shorter the production cycle, the faster the sales and the shorter the debt collection, the lower the working capital will be for a business. Businesses that are less efficient because of their nature will require a higher working capital because of these factors.

Inflation

An increase in the price of raw materials because of inflation will affect the amount needed for working capital. The cost of labor also can increase the need for work capital, unless the company can increase the price of goods as well. If a business can counterbalance inflation with a price increase, the working capital requirement may remain the same. However, depending on specific business practices, price changes may also affect working capital under specific circumstances.

Growth

A growing business may require a larger investment in working capital each month because it may have to invest in more accounts receivable or inventory. For example, a retail business that is expanding will need to invest in more working capital to match its growth. If a business isnt growing quickly or is contracting, it may instead have to consider reducing its investment in working capital.

FAQ

Why is current ratio better than working capital?

Simply put, Working Capital is the leftover amount after paying all the business operating expenses. Whereas the Current Ratio is the ratio or proportion which indicates the efficiency of current assets to pay off current liabilities.

What is the formula for working capital and current ratio?

Working capital ratio formula

The working capital ratio is Working Capital Ratio = Current Assets / Current Liabilities. Using figures from the balance sheet above for example, the working capital ratio would be 300,000 / 200,000 = a working capital ratio of 1.5.

What is the ratio for working capital?

What Is Working Capital? Working capital, also known as net working capital (NWC), is the difference between a company’s current assets—such as cash, accounts receivable/customers’ unpaid bills, and inventories of raw materials and finished goods—and its current liabilities, such as accounts payable and debts.

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