The working capital to debt ratio reflects a company’s ability to settle all of its debts using only its working capital. This metric is particularly crucial for businesses that are nearing liquidation. Through this ratio, they can determine whether or not they are capable of wiping out their debts using working capital alone.
A similar ratio, debt to capital, determine the percentage of debt used by a company to fund its operations as opposed to its capital. The debt to capital ratio is a risk metric that can be used to calculate a company’s ability to manage a drop in sales because it emphasizes the association between debt and equity financing. Total capital covers all interest-bearing debt on top of shareholders’ equity, which can include common and preferred stock, minority interest, and the like.
On the other hand, the working capital to debt ratio only considers working capital and nothing else. Moreover, this ratio differs from the debt to capital ratio in that it is only typically used during extreme circumstances, such as when a company is about to close and decides to dispose of all its assets or working capital to repay its debt.
As soon as its working capital is depleted from all the debt payments, the company will be left with zero funding for operations and eventually led into bankruptcy.
Working Capital to Debt Ratio Formula
Total debt covers both long-term liabilities, like mortgages and loans not maturing until after many years, and short-term obligations, such as loan payments and credit card balances. Working capital includes cash, accounts receivable, and inventory. And accounts payable includes collectibles, raw material and finished product inventories, and current liabilities.
First off, and as mentioned earlier, working capital is the difference between a company’s short-term assets and short-term liabilities. Assets in business can be anything of value that the company owns, while liabilities can be any outstanding debts, like credit and loans. Working capital can also be defined more simply as the cash that a company has at hand to cover its daily expenditures.
In contrast, capital or fixed capital refers to funds used by the company to purchase assets that are necessary for the business to survive over a long period. These generally include non-current fixed assets that serve as resources for long-term income generation. Fixed capital is necessary upon beginning business operations, during expansion or growth, or in any major event or transition occurring in the business.
Like other debt coverage ratios, a value of 1, which simply means a hundred percent coverage, or higher is the best result. Working capital to debt ratio of 1 indicates that the business is fully capable of wiping out its debts with its working capital alone if it had to.
When the working capital to debt ratio is lower than 1, it could be a sign that the business company is in a compromised financial state. Still, this isn’t always the case. Sometimes, a lower ratio can be explained more positively. Such a ratio must nonetheless be investigated further for a more accurate appreciation of the surrounding facts.
Working Capital to Debt Ratio Example
A mutual fund manager wants to assess the liquidity of Eon Publishing, which is about to go out of business, to understand the company’s capacity to settle its outstanding debts.
After seeking the help of his team in calculating the publisher’s working capital to debt ratio, he learned that the company currently has the following:
- Cash: $2,600,000
- Accounts receivable: $5,213,000
- Accounts payable: $6,563,000
- Inventory: $6,686,000
- Total debt: $11,340,500
What is Eon Publishing’s working capital to debt ratio?
We have the total debt number, so let’s first get working capital (numbers in thousands to simplify things):
Now we know that working capital is $7,936,000 we can calculate the working capital to debt ratio:
In this case, the company’s working capital to debt ratio would be 70%.
At the outset, it looks like Eon Publishing will be able to repay all of its debtors, but the fund manager sees that most of the payment will be sourced from inventory, which will be difficult to liquidate. It takes a while to clear out inventory, after all, especially if turnover has been slow.
This means that although they technically have the money to cover their debts with working capital, they could still be at risk because inventory is not as liquid as cash.
Working Capital to Debt Ratio Analysis
Liquidity measures enable investors and analysts to gauge a company’s financial longevity, often by assessing its balance sheet items, like accounts receivable, accounts payable, short-term liabilities, etc.
Among the best ways to understand a company’s general liquidity position is by calculating its working capital to debt ratio. However, to truly understand this value, it is important to know how it differs from the debt to capital ratio, which is essentially a comparison between a company’s total capital and total obligations.
However, when using the working capital to debt ratio as an evaluation metric in stock investment analysis, there is one thing investors and analysts must be careful with. Since inventory is not usually as liquid as accounts receivable and especially cash, a company that has a large inventory in stock but a slow turnover rate will probably have issues using its working capital to settle its debt promptly. It would be unrealistic to expect a large inventory to clear out quickly, which means the company will likely face challenges with debt repayment.
As well, a company might find it wise to include only its short-term debt in the working capital to debt ratio calculation, as this would offer a more accurate view of the immediate debt amount that must be paid.
Working Capital to Debt Ratio Conclusion
- The working capital to debt ratio reflects a company’s ability to pay off all its debt strictly with its working capital.
- This formula requires two variables: working capital and total debt.
- The working capital to debt ratio is usually expressed as a plain decimal value.
- The working capital to debt ratio is often used under extreme circumstances, such as when a company is about to stop operating permanently after it disposes of all its assets and pays all its debts.
Working Capital to Debt Ratio Calculator
You can use the working capital to debt ratio calculator below to quickly determine a company’s capacity to settle all of its debts using only its working capital, by entering the required numbers.
FAQs
1. What is working capital to debt ratio?
The working capital to debt ratio is a metric used in investment analysis that reflects a company’s ability to pay off its total debt with only its working capital. This metric is used in conjunction with the debt to equity ratio and the price to sales ratio, or p/s ratio.
2. What is the formula of the working capital to debt ratio?
The working capital to debt ratio is calculated with the following formula:
Working Capital to Debt = Working Capital / Total Debt
3. What is a good working capital to debt ratio?
Typically, working capital to debt ratio between 1.0 - 2.0 is considered good. In the United States, the average working capital to debt ratio for all public companies is 0.92. However, this does not mean that a higher or lower ratio would be negative, only that it would be out of line with similar company averages.
4. What does the working capital to debt ratio show you?
This metric shows you how much time a company can go before it runs out of working capital, which is the total amount of cash, accounts receivable, and inventory that is available to pay off current liabilities.
High working capital to debt ratio shows that the company has a high level of liquidity, while a low working capital to debt ratio means the company is likely closer to bankruptcy.
5. What is the importance of the working capital to debt ratio?
By understanding the working capital to debt ratio, investors and analysts can gauge a company’s ability to repay its debt. This information is extremely helpful in determining the overall strength of the company’s liquidity position. It also allows for a more accurate comparison between similar companies, as well as comparisons to sector and industry averages.
