Why do we calculate working capital ratio? Having a comprehensive understanding of your working capital is one critical component of analyzing your company’s complete financial well-being. Different from revenue and profit, working capital accounts for the short-term financial health of your business. Here’s a brief breakdown of how working capital functions within your company’s financial framework:
Revenue: Accounts for how much money your company is bringing in total.
Profit: Accounts for how much money your company is making, minus all of your operational expenses.
Working Capital: Accounts for how much money your company has in the current moment to fund immediate expenses.
Jointly analyzing all three of these financial pillars gives you a holistic picture of your business’s financial stability. To properly assess the state of your working capital, you must first calculate and interpret your working capital ratio. The working capital ratio itself measures your company's current assets against your current liabilities. Calculating working capital ratios allows companies to:
Clearly understand how much hard cash your business has on hand to cover daily expenses, liabilities, and incidental costs.
Maintain funding for operations and meet short-term financial obligations despite cash flow challenges.
Continue to foster and fund growth without borrowing additional money and incurring more debt.
Before jumping into your working capital calculations and evaluations, we should explain the working capital ratio vs the current ratio. The working capital ratio and current ratio essentially mean the same thing. Since many sources often use these terms interchangeably, the terminology can often be confusing if not defined upfront.
Before you begin calculating your working capital ratio, you need to gather all of the information related to your current assets and liabilities. These figures are pulled from your company’s balance sheet. Your balance sheet offers a glimpse into all of your company’s short-term and long-term assets and liabilities. Each asset is categorized by liquidity, while liabilities are divided into short-term and long-term groups—long-term liabilities are always listed first. Here’s a breakdown of the different types of assets and liabilities that are likely to be listed on your balance sheet:
Your current assets are things that your business has that have value:
Your cash and cash equivalents
Your raw materials
Your liabilities are things that cost your company money:
Additional yearly debts
Loans and their interest payments
After gathering all of the figures related to your present assets and liabilities you can calculate your working capital ratio. Sourcing the information was the difficult part, but learning how to calculate working capital from a balance sheet is a fairly straightforward process. Here is the official working capital ratio formula:
Current Assets / Current Liabilities = Working Capital Ratio.
We’ve also listed some examples in our next section to help you gain a better understanding of what this looks like in practice.
For the following working capital ratio example, let’s pretend you run a boutique brick and mortar toy company. After reviewing your balance sheet you were able to outline the following figures:
Assets for the Year
Cash and Cash Equivalents: $900
Short-term Investments: $1,000
Accounts Receivable: $400
Property (the building): $120,000
Total Assets: $222,300
Liabilities for the Year
Utility Costs: $4,000
Accounts Payable: $1,000
When you enter these figures into the working capital ratio formula, it should look like this:
$222,300 / $115,000 = 1.9 Working Capital Ratio
Although calculating your working capital ratio is a fairly simple undertaking, conducting a working capital ratio analysis is a bit more complex and nuanced. In this stage, you begin to evaluate your ratio and determine if changes need to be made to your financial plan.
In broad terms, you can either have a “high” or “low” working capital ratio. A high working capital ratio means that you have enough money to cover your liability expenses and will have funds leftover after those bills come due. In contrast, a low working capital ratio means that your business is in a somewhat precarious—although not unsalvageable— financial position. Most financial advisors agree that the ideal working capital ratio falls between 1.5 to 2.0, while a ratio of 1.0 or lower indicates severe financial instability. Although, in some cases this standard may not ring completely true.
So, is it better to have high or low working capital? In short, it’s complicated. The reality is that a good working capital ratio looks different for every business. Although it may be tempting to assume that a higher working capital ratio equates to greater financial health, there are some significant disadvantages of high working capital ratios. A high working capital ratio of two or more could mean trouble for various reasons. For example, a higher ratio can indicate that a business is failing to use its assets to generate the greatest possible revenue. Growth comes at a price, and failing to exploit your assets will inevitably hinder your ability to expand.
To elaborate, there are instances when spending more will earn you more. For example, expanding your workforce can eat into your budget initially but offers greater ROI, especially when it comes to increased productivity. In this case, a temporarily lower working capital ratio was merely the result of “growing pains” as opposed to poor financial performance.
There is also one more aspect to consider— working capital ratio interpretation differs greatly from industry to industry. This is because the financial obligations and rules change depending on what is being sold and who it’s being sold to. Here are three examples of what an ideal working capital ratio looks like for different types of businesses.
Since SaaS companies sell software services, they can easily operate with a lower working capital ratio. This is mainly because they do not have physical inventory and also tend to operate with smaller-sized teams. Although, this does not mean their working capital ratio should routinely drop below 1.0, but operating within the 1.0 or 1.5 range is acceptable for most SaaS businesses.
Working capital for retailers is directly tied to their operating cycle. This means that retailers must account for the amount of time between buying more inventory and the final sales of all inventory. Retailers almost never sell all of their inventory immediately. Sometimes sales come for a while after that inventory was purchased. Because of this, retail companies need to maintain a fairly high working capital ratio since they cannot rely on sales alone to meet their short-term expenses.
When it comes to the food industry, it is common to have a low working capital ratio that slowly increases as the business picks up traction and the restaurant builds a loyal customer base. However, a restaurant cannot stay in the low range for too long. After the restaurant exits the start-up phase, the working capital ratio should increase and eventually stabilize to a comfortable 2.0.
After you have successfully calculated and analyzed your working capital ratio, it’s time to apply changes when necessary. If your working capital ratio isn’t where it needs to be, here are a few tips to help remedy the situation:
Are you spending too much on things that don’t provide enough ROI? Most businesses are, which is why it’s critical for companies to carefully analyze and monitor their variable expenses. Much of this comes from improving your negotiation techniques and cutting deals with your suppliers or vendors.
As we mentioned before, sometimes you do have to spend more money to make more money. But there is such a thing as bad debt, like late payments on utility bills. And as your bad debt increases, your working capital decreases. Therefore, you should not make a habit of extending your trade credit. You can reduce your overall bad debt by taking the following measures:
Collect payments more quickly.
Streamline your credit management strategy.
Increase the margins of your offerings.
When selling physical products, overstocking and inventory shortages are serious issues. Therefore, it is often beneficial for businesses to adopt a digital approach to their inventory management processes. The right inventory management software can reduce losses and interruptions, making this technology well worth the investment.
Put simply, the customers who consistently pay on time should be rewarded. Providing discounts or access to premium content and products are both ways to give your most reliable customers a bit of a boost. This will encourage customers to keep meeting their payment obligations and also increase their loyalty.
If you find yourself in need of supplemental working capital, then partnering with a business lending service might be a good option. At Backd, we believe that financing for small businesses should be quick and easy. This is why we offer:
Speedy application process
We are dedicated to providing small businesses with the short-term funds they need to grow and succeed. With over 3,700 business partners, we have the experience needed to create a loan strategy that is specifically tailored to meet your needs. No matter what your situation is, we’ve got your back. Fill out our application or reach out to us with any questions.