Some Drawbacks to Having a Higher-than-Expected Working Capital Ratio

Some Drawbacks to Having a Higher-than-Expected Working Capital Ratio

The ideal working capital ratio is 2: 1, which basically indicates that a company’s financial position is sound.

While a current ratio that is greater than that may suggest adequate liquidity, anything less than that generally does not. The former result may mean current assets are too high compared to current liabilities, or vice versa. Companies usually benefit from having levels of debt that are low. However, if the current ratio is higher than one, that company could be having underlying operational issues which need attention from management.

A higher-than-average level of cash may suggest that management is not able to find better purposes for using cash, hence limiting their company’s ROI (return on investment). In times of recession, a high balance is perhaps justified as companies hold back on significant investments, due to uncertainty about future sales.

A higher-than-average AR balance could lead to a high ratio. High accounts receivable may suggest that customers continue to delay paying their invoice amounts. In such situations, a high current ratio would not mean sufficient solvency because the company would not be able to turn its accounts receivable into cash rapidly.

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