If you have a net working capital ratio between 1.5 to 2, your business is likely in good financial standing. A ratio between 1 and 1.5 isn’t necessarily the end of the world, but anything lower than that indicates a struggle or complete inability to pay off current liabilities. And while there isn’t really an upper limit to working capital ratio, if your ratio is above 2, it could mean you aren’t using your excess cash in the best way to grow your business.
How exactly do you go about figuring this out? First, it’s helpful to understand the net working capital formula before diving into ratio calculations.
Calculating working capital is relatively straightforward—simply take your current assets minus your current liabilities.
WORKING CAPITAL RATIO FORMULA
Current Assets - Current Liabilities = Working Capital
For a basic example, pretend you have $400,000 in current assets. This would be the sum total of anything your business owns that can be converted into cash quickly, like:
Outstanding Invoices / Accounts Receivable
Cash in the Bank
Once you tally that up, take a look at your liabilities. Let’s assume here that you have $225,000 in liabilities, which would include items such as:
Now you’ve determined you have $400,000 in current assets and $225,000 in current liabilities. $400,000 minus $225,000 equals $175,000. So your net working capital is $175,000.
To calculate your ratio, take your current assets divided by your current liabilities. We will stick with the above example of $400,000 in assets and $225,000 in liabilities for this calculation as well. WORKING CAPITAL RATIO FORMULA Current Assets / Current Liabilities = Working Capital Ratio With these numbers, your ratio would be $400,000 divided by $225,000 for an approximate working capital ratio of 1.78. Not bad! That is well within what is considered a healthy range.
As a reminder, the healthy range for a working capital ratio is between 1.5 and 2. Some businesses can operate comfortably with a lower ratio, but others will need a high ratio to keep operations running smoothly.
Many businesses can easily find themselves under or over that range, and you should regularly conduct a working capital ratio analysis to determine the condition and strength of your business. If your ratio analysis reveals that you aren’t in the healthy range, not to worry—there are solutions for either side of this coin.
Any working capital ratio over 2 is considered high. On the bright side, this means a business has plenty of funds to pay off liabilities and is far from the cliff of bankruptcy. However, a high working capital ratio does raise some questions as to a business’s financial management. For example, if a business has an excess amount of cash in the bank—why aren’t they investing that cash into the business? Letting an overabundance of assets sit idle usually indicates a stagnant business model. It probably won’t make shareholders too happy either. While maximizing liquid assets might initially sound like a wise financial decision, it could mean that a business owner:
Is hoarding assets for fear of the risk associated with investment
Has more inventory than it actually needs to meet demand
Is neglecting growth opportunities
If these issues sound familiar, it’s a good idea to get back to the drawing board on your business plan and goals to find solutions. If your inventory is too high for the current demand, figure out why that is. Are your sales numbers meeting quarterly goals? Is there something happening within current operations that is causing this? If you’re not sure where to start, consider speaking with a business financial advisor to pinpoint exactly what the issues are and ways to settle your working capital ratio.
Working capital ratio under 1.5 is usually considered low. If it’s under one—that’s a serious issue and indicates negative cash flow. This means that a business doesn’t have enough short-term assets to pay off its short-term debts.
However, in certain situations, this may be part of a bigger plan and can be a good thing. Sometimes businesses invest significant assets in hopes of a higher return rate and working capital ratio. These are usually stable, well-established businesses that can afford these kinds of risks.
But if a business faces a low working capital ratio outside of any grand scheme, it’s best to identify what’s causing these issues. Common problems that lead to low working capital ratio include:
Poor debt collection processes
How do you fix this? As with any high working capital ratio, it’s always best to speak with a financial advisor, but here are some solutions to consider:
Perform credit checks before signing on a new customer
Cut any unnecessary expenses
Improve inventory management through things like regular audits and digitizing your management system
Find areas where you can automate process to reduce human error
Negotiate deals and discounts with vendors
If you’ve run through all these solutions and still find your business short on cash, it might be time to consider additional business lending. Sometimes businesses need that extra boost to take off or get back on their feet.
Do you need that little extra boost for your business? Consider financing with Backd! We’re all about helping businesses with alternative financing to traditional loan options. You can get backd in three, easy steps:
Receive a decision from our underwriting team
Get the funds in your pocket after final approval within three days!
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