Want to improve your business’s financial health and efficiency? One key piece of information is your working capital ratio. Knowing this number will help you see how well your business is doing and make smarter choices for the future. Whether you’re a seasoned business owner or new to finance, this guide will help you understand and use your working capital ratio.
What Is the Working Capital Ratio?
Exploring the Basics
The working capital ratio — also referred to as the current ratio — is the ratio between a company’s current assets and its current liabilities. Your current ratio provides a clear snapshot of how well you can cover your current debts with your existing assets. The term is closely related to working capital, which is the difference between your company’s current assets and liabilities.
Current assets can include such things as:
- Cash
- Accounts receivable
- Inventory
- Marketable securities
However, your current assets don’t extend to fixed assets such as commercial real estate or equipment. Your liabilities refer to your monthly operating expenses, such as:
- Accounts payable
- Accrued expenses
- Short-term debt
- Payroll liabilities
- Tax liabilities
Remember: your working capital ratio is only as accurate as the data you use to calculate it. Maintaining clear financial records will help you properly calculate and apply your working capital ratio.
Understanding Its Significance
Your working capital ratio is one of the most vital indicators of your business’s financial health and overall liquidity. The working capital ratio directly reflects your cash flow and solvency. Your cash flow indicates your ability to meet financial obligations, such as covering your bills and completing payroll.
Additionally, if you ever need business funding, your lender will likely use your company’s working capital ratio as a key indicator of your business performance, which can affect the type and amount of loan you qualify for.
Determining a Good Working Capital Ratio
What is a good working capital ratio? Generally, you want to achieve a working capital ratio of 1.5 to 2.0. However, this can vary by industry. Retail businesses aim for a working capital ratio between 5 and 10, while the food and beverage industry generally aims for a ratio between 6 and 11.
Most importantly, your working capital ratio should remain above 1.0. Anything below 1.0 indicates a major cash flow problem, which can jeopardize your ability to meet your obligations. If you’re experiencing a current ratio that’s higher than your industry benchmarks, it could also mean that you’re failing to allocate your resources efficiently or that you have excess money that you should be reinvesting into your business.
How to Use the Working Capital Ratio
How do you actually calculate your working capital ratio? Here are some practical insights to help you better understand this figure.
Step-by-Step Guide
The following guide will walk you through the basic steps you need to take to determine your current assets and liabilities. Then, you’ll convert this data into your working capital ratio.
Step One: Identify Your Current Assets
Your current assets will be listed on your company’s balance sheet. Traditionally, companies list their assets in the left column, usually in order of greatest to least liquidity. But don’t forget — when you calculate your working capital ratio, you’ll ignore your fixed assets, such as your real estate or equipment.
Step Two: Identify Your Current Liabilities
Your balance sheet will also include your current liabilities. This includes the total amount of debt, payroll, and other financial obligations that you’ll owe within that year. This should also include accrued expenses, such as computer/office equipment, loan interest, wage expenses, rent, and utilities.
Step Three: Use the Working Capital Ratio Formula
You’re now ready to calculate your working capital ratio using the following formula:
Working capital ratio = (Current assets) / (Current liabilities)
For example, if your current assets total $215,000 and your total liabilities are $150,000, your working capital ratio comes to 1.4.
Calculating Your Working Capital Ratio
Your working capital ratio is very straightforward — as long as you have access to an accurate, up-to-date balance sheet. But in addition to your working capital ratio, you can also use the same numbers to calculate several other pieces of financial data related to your cash flow.
Working Capital
You can calculate your working capital itself simply by subtracting your assets from your liabilities:
Working capital = Current assets – Current liabilities
So, if your current assets total $250,000 and your liabilities total $150,000, your working capital is $100,000.
Net Working Capital
You can also calculate your net working capital using a calculation that excludes your cash assets and your debt liabilities:
Net working capital = Current assets (minus cash) – Current liabilities (minus debt)
But you can always adjust the formula as follows:
Net working capital = Accounts payable + Inventory – Accounts receivable
Together, these figures will give you a comprehensive understanding of your business’s financial health.
Cash Conversion Cycle
Another critical figure is your cash conversion cycle (CCC), which refers to how quickly you can convert your assets into cash.
The CCC formula is as follows:
CCC = DIO + DSO – DPO
Where:
- DIO (Days Inventory Outstanding) = the number of days you hold inventory
- DIO = (Average Inventory/COGS) x (# of days)
- DSO (Days Sales Outstanding) = the number of days it takes to collect payment
- DSO = (Accounts Receivable/Total Credit Sales) x (# of days)
- DPO (Days Payables Outstanding) = the number of days it takes to pay bills
- DPO = (Average Accounts Payable/COGS) x (# of days)
Thus, your CCC will reflect your overall cash flow, specifically how easily you can convert non-cash assets into spendable cash to cover your financial obligations.
Putting It into Action
Once you calculate your working capital ratio (and any attendant figures), how will you use this data in your decision-making process?
First, a low working capital ratio below 1.0 will indicate major cash flow problems. Should you discover a low working capital ratio, you’ll need to take immediate steps to either improve your cash flow or reduce your operating costs to bring your operating budget into alignment, lest you risk your ability to meet your most basic financial obligations.
Similarly, you can use your working capital ratio to compare your company’s performance to industry benchmarks. If your current ratio is above these standards, you may consider ways of allocating your funds more efficiently or investing in new business opportunities. Proper working capital management can ensure that you maintain efficiency as well as your organization’s financial health.
Examples of Calculating the Working Capital Ratio
What are the practical implications of understanding your working capital ratio? Here are some examples to consider.
Real-World Scenarios
There are several key reasons why it’s important for business leaders to understand the role that this data plays in measuring their business performance and progress toward key financial benchmarks.
Here are some examples of how businesses can use a working capital ratio in a meaningful way.
Case Study One: New Startup
First, consider the case of a new startup. After one year in operations, the business owner conducts a thorough review of the company’s internal processes and financial operations. Problems arise when the owner realizes that the company is hemorrhaging money.
Currently, the company’s total assets are $150,000, but the total liabilities come to $300,000. This sets the working capital ratio at 0.5, which means that the business cannot cover its financial obligations even if the company could liquidate its non-cash assets.
Does this mean that the company is a failure? No, it just means that the business owner will likely need to make some crucial decisions in the immediate future. This may include strategizing ways to reduce overhead costs, but since the business is new, a working capital loan may be appropriate until the business begins to generate sufficient cash flow to cover its immediate financial obligations.
Case Study Two: Large Enterprise
What about a larger business entity? Imagine that a food and beverage company totals its current assets at $38 million while its liabilities sit at just $2.4 million. This gives the company a working capital ratio of 15.8. This is a high number and well above the industry benchmark. But isn’t that a good thing?
In some cases (such as this one), a high working capital ratio can indicate problems with the company’s fundamental efficiency. Since this is an established company, the best decision would be to seek ways to reinvest this extra working capital in the business.
The company could invest in new equipment or hire a new worker — such as a marketing director — to scale its operations, introduce a new product line, or strategize ways to reach untapped markets.
Interpreting the Results
In both of these cases, the working capital ratio was key in evaluating each company’s short-term financial health. The more emergent scenario occurs when the current ratio drops below 1.0, indicating a clear need to adjust spending or increase cash flow to ensure proper operations.
The harder decision can be when your working capital ratio exceeds industry benchmarks. This may indicate a failure to efficiently use your liquid capital, which means you’re not operating at peak efficiency. The best way to address this scenario is to reinvest back into your business. Find ways to invest money in ways that align with your goals, such as:
- Improving or repairing existing equipment or real estate
- Distribute bonuses to your employees
- Opening additional locations
- Investing in a new product or service
- Hiring additional employees
- Pay down existing debt
The point is to bring your cash inflow and outflow into greater harmony to achieve consistently smooth operations throughout your organization.
Working Capital Ratio vs. Current Ratio
Comparing and Contrasting
Business leaders often use the terms “working capital ratio” and “current ratio” interchangeably. That’s because both terms refer to the exact same metric and use the same formula to calculate the ratio of a company’s assets to its liabilities.
If there’s a difference, it may be that some business leaders use the “working capital ratio” in a broad way to describe working capital management, whereas the “current ratio” refers to the metric itself.
Practical Applications
Remember: the current ratio and working capital ratio are identical concepts, and most use the terms interchangeably. You might use “working capital ratio” when speaking of your management strategies, while “current ratio” refers more specifically to the number itself. Both terms will help you evaluate your company’s working capital, current assets, and liabilities. But don’t forget that working capital is different from your working capital ratio.
Your Key to Financial Resilience
The more you learn to master your working capital ratio, the more you’ll be able to remain resilient in the face of financial challenges. Given the relative simplicity of this calculation, business leaders should determine their current ratio at regular intervals to evaluate their progress. By using the best available data, you’ll be better equipped to navigate a competitive marketplace.