Before you dive in:
A working capital ratio indicates how financially prepared a company is to meet its current obligations.
Small business managers can calculate the working capital ratio to quickly determine where the company stands.
The working capital ratio is based on a business’s current assets and current liabilities.
Determining a Good Working Capital Ratio
The exact working capital ratio to aim for varies based on the unique situation of the business. But in general, a good working capital ratio falls between 1.5 and 2.0.
Assets vs liabilities: First things first, it’s important to aim for a positive working capital ratio. The goal is to have the current assets of the business outweigh its current liabilities.
Measured liquidity: If a company’s working capital ratio falls below 1.0, it may need to raise money to cover the shortfall. But aiming for a working capital ratio between 1.5 and 2.0 gives business managers some much-appreciated breathing room.
What Is the Working Capital Ratio?
Business managers can determine the working capital ratio by dividing the current assets by the current liability. Here’s what the formula looks like:
Current Assets / Current Liabilities = Working Capital Ratio
How Do You Calculate the Working Capital Ratio?
The math behind the working capital ratio is relatively simple. Let’s walk through an example.
Add up current business assets: This includes inventory, accounts receivable, notes receivable, prepaid expenses, and cash. In this example, let’s say that your business has $20,000 in current assets.
Add up current business liabilities: This includes accounts payable, wages payable, taxes, expected debt payments, dividend payables, and unearned revenue. In this example, let’s say that your business has $10,000 in current liabilities.
Divide current assets by current liabilities: In this case, you would divide $20,000 by $10,000 to arrive at a working capital ratio of 2.0.
High Working Capital
A higher working capital ratio means that a company is prepared to meet its upcoming financial obligations.
At first glance, a high working capital ratio might seem like a good thing. But too much of a good thing can actually turn out to be a bad thing. In the case of working capital, having a ratio much higher than 2.0 means that the business isn’t making the most of its resources.
Low Working Capital
A lower working capital ratio means that a company may struggle to meet its current financial obligations.
Typically, this means the company will struggle to pay back creditors. In some cases, the negative working capital can be negative. Ultimately, a low working capital could lead to significant financial trouble ahead.
Good Working Capital Ratio
The best working capital ratio varies from business to business. But most experts consider a good working capital ratio to fall between 1.5 and 2. At this level, a company can meet its current financial obligations without hanging on to cash that could be better utilized in another way.
Example of a Good Working Capital Ratio
Let’s explore some contrasting working capital ratios:
Company 1 with a working capital ratio of 1.75: With this healthy working capital ratio, company 1 is ready and willing to meet its financial obligations. Plus, there’s some breathing room to fall back on if something doesn’t go according to plan.
Company 2 with a working capital ratio of 1.1: Company 2 has a razor-thin working capital situation. Depending on the situation, the company might even be struggling to pay its vendors on time. If anything goes wrong, the company could face financial ruin.
Why the Working Capital Ratio Matters
The working capital ratio matters because it can tell you a lot about your company’s financial picture. Although some companies function with a negative working capital ratio, most companies require a positive working capital ratio to pay their financial obligations on time.
Monitor for changes: A major shift in your working capital ratio could indicate a bigger underlying problem. The metric can give you a warning sign that you need to look into.
Liquidity matters: Most companies require a positive working capital ratio to meet their financial obligations. A low working capital ratio could indicate signs of future financial trouble.
The Working Capital Ratio and Company Liquidity
The working capital ratio is closely tied to a company’s liquidity.
Not enough liquidity: Most experts recommend keeping the working capital ratio between 1.5 and 2. If the ratio is lower, then the company might not have enough cash available to pay its bills.
Sufficient liquidity: Companies with a working capital ratio between 1.5 and 2 often have enough capital on hand to cover their operating costs.
Too much liquidity: In some cases, too much liquidity could be a bad thing. For companies trying to grow, a working capital ratio above 2.5 could indicate that they aren’t getting the most value out of their available resources. But some other companies prefer the wiggle room provided by this extra liquidity.
Improving the Working Capital Ratio
The working capital ratio can have a significant impact on your business. Here’s how to improve it:
Optimize accounts receivable: Automated invoice reminders offer one way to improve accounts receivable timelines. Also, consider providing incentives to consumers to increase the speed by which you get paid for providing goods or services.
Finance fixed assets with long-term loans: Instead of financing major purchases with short-term working capital, stretch out the financial obligation into a longer loan term.
Conduct credit checks for customers: If you provide financing to customers, consider running a credit check before finalizing the deal to minimize the risk of non-payment.
Alternatives to the Working Capital Ratio
The working capital ratio isn’t the only way to assess the financial health and liquidity of your business. Let’s explore a few other ways to assess your company’s financial health.
The Cash Conversion Cycle
The cash conversion cycle measures the number of days it takes a company to convert its inventory into cash. If a company has significant resources tied up in inventory, the cash conversion cycle is a critical metric. A long cash conversion cycle means less liquidity than a company with a short cash conversion cycle.
The Quick Ratio
The quick ratio, or acid test ratio, measures a company’s short-term liquidity by dividing a company’s more liquid assets by its total current liabilities. Assets included in this ratio include cash, cash equivalents, marketable securities, and accounts receivables.
Since the quick ratio removed inventory from the equation, it’s often considered a more conservative metric than the working capital ratio, which can include inventory.
The Cash Ratio
The cash ratio offers another way to measure a company’s liquidity. But it takes things a step further by only including a company’s cash and cash equivalents as a part of its current assets. This number is divided by the company’s current liabilities.
Typically, the cash ratio is considered the most conservative liquidity measurement because it only takes cash into account.
FAQs about the Working Capital Ratio
Have questions about the working capital ratio? We have answers.