How to use the working capital ratio to keep your business healthy
3 minutes read
Businesses don't go bankrupt because they are not profitable. They go bankrupt because they run out of cash and can't 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. The working capital ratio can help you avoid this pitfall.
What is working capital?
"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.
Current liabilities include an operating line of credit from a bank, accounts payable, the portion of long-term debt expected to be repaid within the next 12 months, and accrued liabilities such as taxes payable. All these items turn over and change in value on an ongoing basis.
How do I calculate my working capital ratio?
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.
The working capital ratio is calculated as follows:
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.