Determining, a company financial health is important before investing. Recently, I met a person, who is a professional trader cum investment. His approach towards the stock market is different. He is not like any other trader or investor who invest in stock market through others words. He suggested me to study the Working Capital Ratio which might helps in studying the company's financial health.
The working capital ratio is a key indicator of a company's financial health and short-term liquidity. It reveals whether a company can meet its immediate obligations with its readily available assets. A good ratio indicates that the company is managing its current assets effectively and not holding excessive amounts of inventory or cash. From an investment prospective, consider working capital ratio as a quick test to see how easily a company can pay off its short-term debts.
Formula:
Working Capital = Current Assets – Current Liabilities
Working Capital Ratio = Current Assets ÷ Current Liabilities
Example:
If a company has ₹8 crore in current assets and ₹4 crore in current liabilities, the ratio is 2 i.e. (₹8 ÷ ₹4)
This means that the company has double the assets compared to its short-term debts, which is generally a good sign.
How the ratio help ?
Ratio around 1 : The company might face trouble paying short-term dues.
Ratio 2 or more : Usually healthy, but could also mean the company is sitting on excess cash or stock that could be better invested or given as dividends.
By monitoring the working capital ratio, businesses can identify potential issues early on and take corrective actions to ensure they maintain a healthy financial position and avoid future problems.
Do remember that, the quality of assets matters too. Two companies can have the same ratio, but the one with more cash can pay its debts faster.
In good faith - Peace!!
