We’ll break it down in this article.
Before You Dive In
- Current ratio measures the ability to pay short-term obligations
- Working capital is the cash left over after paying those obligations
- Understanding how both impact your company can help you keep operations efficient
Current Ratio vs Working Capital
Current ratio and working capital are similar in many ways but ultimately focus on two different things.
Your company’s current ratio measures whether your business is able to meet its current obligations. A ratio of 1 or more means it has enough current assets to pay the bills.
Working capital looks at what is left over after paying current obligations. It measures flexibility and how much money your company can spend on other things.
We’ll explain each concept in depth so you can understand how they are similar and how they differ.
What Is the Current Ratio?
Current ratio measures your company’s ability to pay the bills.
Definition of Current Ratio
Current ratio is a business liquidity ratio. It measures your company’s ability to pay debts that are due in one year or less. It’s important to maintain a good current ratio because low current ratios indicate an inability to pay the bills and a risk of bankruptcy or default.
Current Ratio Formula
The formula for finding your company’s current ratio is:
Current assets / current liabilities = current ratio
A current ratio of 1 or more indicates that your company has the assets to pay its debts. Ratios under 1 mean you’ll have to find other sources of money to pay your immediate obligations. In general, companies want current ratios a bit higher than 1 to offer flexibility when paying the bills.
Example of Current Ratio Calculation
Imagine your business has $15,000 in inventory, $20,000 in accounts receivable, and $50,000 in cash. It owes $40,000 to suppliers and will pay $30,000 in rent this year.
That means that its current ratio is:
($15,000 + $20,000 + $40,000) / ($40,000 + $30,00) = 1.07
Interpreting the Current Ratio
Interpreting a current ratio is as simple as looking at how big the number is. Smaller numbers indicate that a company has less money to pay its bills. If the ratio is under 1, the company has more debts due in the next year than it has assets that it expects to turn into cash within the next year.
In general, this is a bad sign, though in some cases it might not be a cause for alarm.
Current ratios over 1 mean a business has the assets to pay for its obligations. However, very high current ratios can show a company that is failing to use its resources efficiently to grow the business.
How the Current Ratio Is Used
Businesses can use current ratio calculations to make important decisions.
At its most basic, current ratio tells you if your company can pay the bills. If it’s less than 1, it can be a sign that you need to make changes to handle upcoming bills. You might see a low current ratio and decide that you need to cut spending or raise your prices to try to reduce your liabilities and boost assets.
High current ratios can show that you have plenty of cash available to pay the bills. That might lead you to make the decision to invest extra money in expanding your company, opening a new location, or starting a new product line.
Why It’s Important to Know Your Current Ratio
The simple reason that knowing your current ratio is important is that it’s an easy way to know if your company is able to pay the bills. If it drops low, you’re going to run into money issues sooner or later. If it’s high, you’ll know that your business is running smoothly.
Limitations of Current Ratio
Current ratio doesn’t show the whole picture, even if it’s a useful metric.
For example, comparing the current ratio of two companies isn’t very useful, especially if they are in different industries because capital needs might vary greatly between them.
Current ratio also considers all of a company’s current assets equally, even though they aren’t equal in reality. Inventory, for example, shows in current ratio, but you can’t spend inventory or use it to pay a bill. You need cash to do that.
An inventory-heavy but cash-light business might have a great current ratio but not be able to pay the bills.
What Is Working Capital?
Working capital is another popular business metric that focuses on current assets and liabilities.
Definition of Working Capital
Working capital is the difference between a company’s current assets and current liabilities. In short, it measures how much money will be left over after paying all the bills and is a good measure for the short-term financial health of a business.
Working Capital Formula
To find working capital, you can use this formula:
Current assets – current liabilities = working capital
Example of Working Capital Calculation
Using the same example as we did previously, imagine your business has $15,000 in inventory, $20,000 in accounts receivable, and $50,000 in cash. It owes $40,000 to suppliers and will pay $30,000 in rent this year.
That means that its working capital is:
($15,000 + $20,000 + $40,000) - ($40,000 + $30,00) = $5,000
Interpreting Working Capital
Working capital shows two things: financial health and operation efficiency.
A company with positive working capital generally has the resources it needs to pay its bills and maintain its daily operations. Negative working capital means it might not have enough money to cover its obligations.
In general, higher working capital also indicates more operational efficiency and shorter inventory turnover and operational cycles.
How Working Capital Is Used
Working capital is used by business owners in a few different ways.
One is simply to understand if the company can pay its bills. Business owners want to make sure that working capital remains positive so the company can pay the bills.
Another is to gauge the company’s flexibility. The more working capital the business has, the more flexible it can be with paying its bills or investing its money in expansion or things other than keeping the lights on and the company running.
Why It’s Important to Know Your Working Capital
The number one reason business owners need to pay attention to working capital is that it shows whether you can pay the bills. If it falls below $0, your company doesn’t have the money to pay the bills.
An increase in working capital can also indicate that your company’s operations are improving, giving you the chance to try to invest in growth. On the other hand, shrinking working capital can be a sign of problems and give you the chance to try to fix your operations before disaster strikes.
Limitations of Working Capital
Like current ratio, working capital has some drawbacks.
For example, comfortable levels of working capital vary from company to company and industry to industry. For example, larger companies need more working capital than smaller ones.
Working capital also ignores the true liquidity of assets. Inventory and accounts receivable count the same as cash even though you can’t use them to pay bills in the same way.
Working capital is also constantly in flux. Company assets and liabilities always change. Your working capital might look good one day but drop the next day, so you need to keep a close eye on it.
Differences Between Current Ratio and Working Capital
|Current Ratio||Working Capital|
|Definition||The ratio of your current assets to liabilities||The difference between your current assets and liabilities|
|Formula||Current Assets / Current Liabilities||Current Assets – Current Liabilities|
|Example||(Inventory + Cash + receivables) / (payables + wages owed + rent)||(Inventory + Cash + receivables) - (payables + wages owed + rent)|
|Interpretation||Can the business pay its current bills||How much money is left after the company pays its bills|
|Usage||Identifying potential inability to cover debts||Identifying changes in a company’s operational efficiency|
|Limitations||Good current ratios vary between companies and industries||Good working capital levels vary between companies and industries|