Financial Ratios for Personal Evaluation: Working Capital Ratio
I’m a fan of using financial reports to analyze my personal financial position and progress. I’ve done this so far using basic reports, like the balance sheet and income and expense report. When investors and decision makers analyze companies, they also look beyond these statements. There are a number of ratios or comparisons that tell a better story, especially when these ratios are examined over time.
One of these is the working capital ratio, also known as the “current ratio.” This ratio describes how well one can meet short-term debt obligations. It answers the question, “Will I be able to make all of my payments this year?” The working capital ratio compares current assets and current liabilities. When evaluating businesses, for assets and liabilities to be “current,” they are either convertible to cash within a year (assets) or due to creditors within a year (liabilities).
For personal finances, I think using a month for this comparison rather than a year tells a better story. That’s how I’ll perform my calculations. In order to determine working capital ratio, I’ll use the numbers from the end of 2006.
My current assets include my cash, savings, checking accounts, and accounts receivable, including both personal and business accounts. I don’t include any of my brokerage investments or retirement accounts. Even though I could sell those assets within a month, I’d rather leave them in illiquid state.
My current liabilities include my full credit card balance and my monthly payments for my car ($300) and my student loan (about $150). The ratio is simply the current assets divided by the current liabilities. Here are my results.
The table above shows the last four months. The ratio seems to fluctuate from month to month due to my holiday spending. But are these numbers any good? Any ratio higher than 1.00 means I will be able to meet my short-term debt obligations. A business might be happy with a ratio around 2.00. This is high enough to meet obligations with wiggle room, but not so high that an excessive amount of capital is held in cash when it could be invested, earning more money.
I think 2.00, while possibly ideal for business, might be too low for evaluation of an individual’s financial situation. It may be a sign of too much debt leverage. Leverage can be risky, and one person’s tolerance for risk may be different than another’s. The optimal working capital ratio may vary from one individual to another, and may not operate on the same principle of the optimal business ratio.
Nevertheless, I think my ratio may be too high. The best solution isn’t taking on more debt, but more efficiently investing my cash and savings accounts. However, my cash is all ready earning between 4.5% and 5.0% APY. I may need much of the funds in the next year or so if I decide to put a down payment on a house, so I’m not too concerned with optimizing my cash investment at the moment. At this point, I’ll just let the ratio stay high.
Every once in a while, I’ll look at another ratio that can help describe someone’s financial condition — specifically mine.