Can working capital be too high?

A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an indication of operational inefficiency. A high ratio can mean a company is leaving a relatively large amount of assets unused for purposes of reinvesting available capital to grow and expand its business.

Working capital is an important concept in the fundamental analysis of a company. An examination of a company's working capital position provides an indication of how financially sound the company is and how efficiently it is being managed. The working capital ratio is considered a key metric of liquidity and is often used in conjunction with the current ratio to gauge a company's ability to handle all of its short-term obligations.

The working capital ratio is calculated by dividing a company's current assets by its current liabilities. For this calculation, current assets are assets a company reasonably expects to be converted into cash within one year or one business cycle. This includes items such as inventory, accounts receivables, and cash or cash equivalents. Current liabilities include accounts payables, leases, income taxes and payable dividends.

An examination of working capital takes into account key elements of a company's basic business operations, such as inventory, accounts receivables and accounts payables. How well a company manages each of these key elements is ultimately reflected in the company's working capital ratio. Exceptionally efficient or inefficient handling of any of these basic business operations clearly impacts a company's working capital position.

A working capital ratio of 1.0 indicates the company's readily available financial assets exactly match its current short-term liabilities. While a ratio of 1.0 indicates a company should be able to adequately meet its short-term obligations, analysts prefer to see a ratio higher than 1.0, indicating the company has excess working capital left over beyond just being able to pay its expenses. Excess working capital provides some cash cushion against unexpected expenses and can be reinvested in the company's growth. A ratio below 1.0 is unfavorable, as it indicates the company's current assets are not sufficient to cover their near-term obligations.

A working capital ratio somewhere between 1.2 and 2.0 is commonly considered a positive indication of adequate liquidity and good overall financial health. However, a ratio higher than 2.0 may be interpreted negatively. An excessively high ratio suggests the company is letting excess cash and other assets just sit idly rather than actively investing its available capital in expanding the company's business. This indicates poor financial management and lost business opportunities.