Do you know what your working capital ratio is? If you run a business, it’s an important number to understand.
You probably know that working capital is an important measure of your company’s financial health. “Working capital” refers to the funds that help you meet the daily expenses and needs of running of your business, such as payroll or paying for software, tools, and supplies. So where does this ratio fit in and how can you use it to inform your decisions?
In this article we’ll explore what working capital ratio is, why it matters, how to calculate it, and what to do with this information.
What is a Working Capital Ratio?
Your working capital ratio is the expression of the proportion of your business’ current assets to its current liabilities. As a metric, it provides a snapshot of your company’s ability to pay for any liabilities with existing assets.
Assets are defined as property that the business owns, that can be reasonably transformed into cash (equipment, accounts receivables, intellectual property, etc.).
Liabilities are the debts that the business owes (loans, wages, accounts payable, etc.)
Why Does Your Working Capital Ratio Matter?
Business owners, accountants, and investors all use working capital ratios to calculate the available working capital or readily available financial assets of a business. It’s an important marker because it can be used to gauge the company’s ability to handle its short-term financial obligations such as payroll, debts, and other bills.
As an entrepreneur, it matters to you almost daily because it’s a vital barometer of your company’s financial health. This ratio can also help you predict upcoming cash flow problems and even bankruptcy.
How Do You Calculate Your Working Capital Ratio?
While working capital is calculated by subtracting current liabilities from current assets, your working capital ratio is calculated by dividing current liabilities from current assets:
Working Capital Ratio = Current Assets ÷ Current Liabilities
For example, if your business has $500,000 in assets and $250,000 in liabilities, your working capital ratio is calculated by dividing the two. In this case, the ratio is 2.0.
What’s a Healthy Working Capital Ratio?
Anything in the 1.2 to 2.0 range is considered a healthy working capital ratio. If it drops below 1.0 you’re in risky territory, known as negative working capital. With more liabilities than assets you’d have to sell your current assets to pay off your liabilities. Negative working capital is often the result of poor cash flow or poor asset management. Without enough cash to pay your bills, your business may need to explore additional business funding to pay its debts.
Got a ratio over 2.0 and think you’re golden? It’s not quite that simple. Higher ratios aren’t always a good thing. Anything about 2.0 could suggest that the business isn’t using its assets to their full advantage to grow the business. So if growth is your goal, take note.
What Your Working Capital Ratio Can Tell You
As in all things accounting, interpreting your working capital ratio isn’t black and white. It all depends on your industry, growth phase, or even the impact of seasonality. For example, if you just make some big purchases or hires to service a contract with a big new client, then your ratio will fluctuate as your assets increase.
Assets can take time to shift, so you may see a misleading working cap ratio for a few months. But not always. Some companies live with constant negative working capital (Amazon, Walmart, etc.). However, because they can turn their inventory over quickly or sell to customers before they’ve even paid for the inventory, it doesn’t become a problem.
Another reason for working capital ratio fluctuation is accounts receivable. If you’re struggling with late-paying clients or are forced to offer trade credit to stay competitive, until the cash is in the bank your assets take a dive resulting in a skewed, albeit realistic, metric.
How Much Should I Worry About My Working Capital Ratio?
As you can see, working cap ratios and what they tell you can vary from company to company, by industry, and seasonality. But don’t ignore your ratio. Get to know it. Learning how to get working capital is important.
Data is power, so use it as a tool, alongside your cash flow forecast, to see how you’re managing your assets and liabilities. Lean on it to guide your financial decisions, such as whether you need a new source of funds like a line of credit, or when you might need to address issues like late paying clients, slow sales, or other expenses.