Definition
The term working capital to debt ratio refers to a measure that assesses the ability of a company to pay off its debt using working capital. The working capital to debt ratio is useful to understand when a company is nearing liquidation.
Calculation
Working Capital to Debt = Working Capital / Total Debt
Where:
Working capital is equal to cash plus accounts receivable, plus inventory, minus accounts payable.
Explanation
Liquidity measures allow the investor-analyst to understand the company's long term viability in terms of fiscal health. This is usually assessed by examining balance sheet items such as accounts receivable, use of inventory, accounts payable, and short-term liabilities. One of the ways to understand the overall liquidity position of a company is by calculating their working capital to debt ratio.
The working capital to debt ratio takes the sum of working capital (accounts receivable, cash, and inventory) and subtracts accounts payable. This value is then divided by the debt of the company. The metric is only useful under certain conditions, such as a decision to liquidate the assets of the company. For example, only under extreme circumstances would a company consider using all of its working capital to pay off debt. Once the company's working capital is depleted, it has no more funding to operate and would likely be forced into bankruptcy.
Example
The manager of a large mutual fund would like to assess the liquidity position of Company ABC. He believes Company ABC is likely to go out of business and needs to understand the company's ability to pay back its debt owed to lenders. The manager asked his analytical team to calculate the company's working capital to debt ratio. The information below was found by his analysts included cash of $5,200,000, accounts receivable of $10,425,000, inventory of $13,372,000, accounts payable of $13,125,000 and debt totaling $22,681,000.
The working capital to debt ratio would then be:
= ($5,200,000 + $10,450,000 + $13,372,000 - $13,125,000) / $22,681,000= $15,877,000 / $22,681,000, or 70%
While it seemed like Company ABC might be able to pay off most of its debt, the analyst noted most of the payment would come from inventory, which will be hard to liquidate.
