What it is:
A company's working ratio measures its ability to cover its annual expenses.
How it works/Example:
A company's working ratio indicates whether or not it is capable of at least breaking even by dividing its annual expenses by its annual revenues as shown:
A company with a ratio of 1 or less is capable of covering its expenses. A company with a ratio of 1 or greater is incapable of covering expenses.
To illustrate, suppose that in a given year company XYZ's yearly expenses (less debt and depreciation) amount to $2 million. In addition, company XYZ's total revenues for that year were $1 million. In calculating the ratio, we find the following:
Working Ratio = $2 million (yearly expenses less debt and depreciation) / $1 million (yearly gross revenue)
Working Ratio = 2
With a working ratio of 2, company XYZ was unable to cover its expenses.
Why it matters:
A company's ability to cover its own costs speaks to the financial health and viability of that company. The working ratio serves as a clear indicator of financial health because it not only reflects whether or not a company can clear expenses, but also the degree to which this is so.