What is a working capital ratio?

"Working capital" is the money you need to support short-term operations. It is this focus on the short term that distinguishes working capital from longer-term investments in fixed assets or R&D.

Working capital is the difference between current assets and current liabilities. "Current" again refers to the fact that these items fluctuate in the short term, increasing or decreasing along with operating activities. Current assets include cash, short-term investments, accounts receivable and inventories. Current liabilities include an operating line of credit from a bank, accounts payable, the portion of long-term debt expected to be repaid within one year, and accrued liabilities such as taxes payable. All these items turn over and change in value on an ongoing basis.

The working capital ratio is calculated simply by dividing total current assets by total current liabilities. For that reason, it can also be called the current ratio. It is a measure of liquidity, meaning the business’s ability to meet its payment obligations as they fall due.

In general, the higher the ratio, the greater your flexibility to expand operations. If the ratio is decreasing, you need to understand why. The ideal ratio depends on your industry and particular circumstances. If it is less than 1:1, this usually means you are finding it hard to pay bills. Even when the ratio is higher than 1:1, you may have difficulty, depending on how quickly you can sell inventories and collect accounts receivable. A ratio of 2:1 usually provides a reasonable level of comfort.

To calculate the business's operating cycle, find out how long it takes to sell inventories and collect accounts receivable. A business with a long operating cycle should have a higher working capital ratio than one with a shorter cycle.

Businesses don't go bankrupt because they are not profitable. They go bankrupt because they run out of cash and cannot meet their payment obligations as they come due. Profitable, growing companies can also run out of cash, because they need increasing amounts of working capital to support additional investment in inventories and accounts receivable as they grow.

For further information go to our working capital project.