Is a High Working Capital Ratio Good?

8 May 2022

Is a High Working Capital Ratio Good?

Whether a company would benefit from a high working capital ratio is a very complicated question, and the honest answer is, it depends. To break it down into its simplest terms, your working capital is the amount of money your business has right now for immediate expenses. Your working capital ratio is the current assets divided by the current liabilities, so how much you have versus how much you owe. 

Essentially, a high working capital ratio means your company has a lot of money available to pay immediate expenses. This overall seems like a good thing, and it can be a great position to be in. It normally means you will not struggle to meet payroll, have plenty of resources to cover unexpected costs that may come up, and do not need to spend time and energy looking for extra funding.

However, it can also mean that your company is not investing enough into growth. If a company keeps many of its assets liquid and does not invest it back into the company, it may not be able to keep up with leaders in the industry, develop new products, or upgrade its technology to keep pace with customer demands.

Now that we have a general overview of the topic, let’s go through each piece of this puzzle in more detail.

What Is Working Capital Ratio?

Your company’s working capital ratio is something you calculate from the financial records and balance sheet of the company. The basic formula is: assets / liabilities = working capital. Your company’s assets are things of value in your business and include things like: 

  • inventory

  • cash

  • raw materials

  • property

  • accounts receivable

  • royalties

Liabilities are things that cost your business money, like:

  • wages

  • accounts payable

  • loans

To give a concrete example of a very simple business, let’s go through this calculation for a kid’s lemonade stand. 

  • Assets Total = $70

    • Inventory - $10 worth of lemons and sugar

    • Cash - $10 of change in the cash box

    • Property - $50 worth of cups, a pitcher, and physical stand

  • Liabilities Total = $40

    • Wages - $10 to the neighbor kid for helping

    • Accounts Payable - $10 owed to your parents for bottled water and ice

    • Loans - $20 owed on the physical stand to your big sister (who built it)

Using the working capital ratio formula for this example, assets of $70 divided by liabilities of $40 equals a working capital ratio of 1.75. This is not an exceptionally high working capital ratio, but let’s look into what this number might mean for a business in the next section.

What Is the Industry Average for Working Capital Ratios?

Overall, most financial advisors would say that a working capital ratio between 1.5 and 2.0 represents a financially healthy zone for most businesses. There will always be exceptions, and a company could fall outside that zone and still be in a very good position, especially if the ratio changes dramatically for only a short period of time. This can often happen during rapid growth or expansion phases, or for seasonal businesses during specific times of year.

There are some industries where this ratio is expected to fall in even more specific ranges, though. Let’s look at some examples below:

  • Software-as-a-Service Companies - 1.0 - 1.5 ratio due to lack of physical inventory and relatively small number of employees.

  • Brick and Mortar Retail - higher ratios due to longer periods between buying inventory and final sales.

  • Restaurants - lower ratios during startup phase that grow to around 2.0 once established. 

What Are the Disadvantages of a Low Working Capital Ratio?

A low ratio means that there isn’t much difference between the money your business has available and how much it is spending. If this ratio is 1.0, that means a business’s available funds match how much it spends, essentially meaning there is no money left in the business account each month after all the bills are paid. Although, theoretically a working capital ratio of 1.0 does mean a business is able to pay all of its bills, a ratio this low is generally not considered ideal because it means there is no financial cushion in case of an unexpected expense or slight slowdown in incoming funds. Generally, a ratio above 1.2-1.5 (depending on the industry) is considered best.

What Happens if the Working Capital Ratio Is Too High?

In some cases, a high working capital ratio can be looked at unfavorably. A ratio above 2.0 might indicate problems with the way a business is monitoring its finances. If a business has a large value of assets that are not being used to pay for regular business operations or grow and expand the business, these assets aren’t necessarily serving their purpose well. 

Let’s say, for instance, that a company has a large amount of inventory, but does not regularly purchase more or pay more staff. This may show they are not selling their product well or are keeping too much inventory on hand compared to their sales rate. Reducing the amount of inventory they have and increasing the amount they spend on marketing might improve their business.

Is It Better To Have a High or Low Working Capital Ratio?

Ideally, it's best to have a working capital ratio that’s just right for your business! Generally, this will be between 1.5 and 2.0, but each business will have a ratio that works best for them, and it may change over time. 

If you are in a growth phase, just starting out, in an off-season of a seasonal business, or need a quick influx of working capital for any other reason, Backd has you covered! We provide alternative funding for small businesses that is fast and easy to apply for. We are in the business of funding dreams and possibilities, so contact us today to start making your business dreams a reality!