Working capital ratio
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Managing your working capital – the money going in and out of your company – is one of the most important aspects of keeping your business afloat. One of the easiest ways to calculate your ability to pay your bills and loan repayments in the coming 12 months is the working capital ratio.
The working capital ratio formula is calculated by subtracting your liabilities – think bills, loan repayments and overheads – from your assets. These can include cash on hand, payments due in that time and anything sellable within the timeframe under review. The output of this working capital calculation will give you a good idea of your ability to stay solvent and keep operating. If you find yourself with a negative ratio, then you might need to consider a working capital loan.
Here we’ll dig into how the working capital ratio works, how to understand it and, most importantly, how to use it to manage your working capital on a day-to-day basis.
Working Capital Ratio Definition
The working capital ratio, also known as the current ratio, is a financial metric that indicates a company's ability to cover its short-term obligations with its short-term assets. In simpler terms – can you pay your costs with the assets you have over a certain period. This ratio is an important tool for understanding how well you’re using the liquidity in your business and how well you’re operating.
The formula for the working capital ratio is:
Working Capital Ratio = Current Assets ÷ Current Liabilities
Why the Working Capital Ratio Matters
While it’s not the complete picture, your working capital ratio is a useful indicator of financial health. Running out of cash is one of the most common issues for small businesses failing and the working capital ratio gives a snapshot of your financial health over a certain period.
The number can help you see whether your business is in a position to pay the necessary operational costs – think rent, utilities and staffing costs – with the revenue and assets available. If you find yourself with a negative ratio, you can take steps to remedy the situation, for example by renegotiating costs, increasing prices or taking out a working capital loan.
How to Calculate the Working Capital Ratio
To calculate the working capital ratio, divide your current assets by your current liabilities.
Current assets include:
- Cash
- Accounts receivable
- Inventory
- Any other assets that can be converted into cash within a year.
Current liabilities are short-term obligations that are due within a year, such as:
- Accounts payable (money owed)
- Short-term debt
- Tax owed within a year
- Salaries and wages
Example Calculation
Consider a small business with the following financials:
Current Assets:
- Cash: £30,000
- Accounts Receivable: £40,000
- Inventory: £20,000
- Prepaid Expenses: £10,000
= Total Current Assets: £100,000
Current Liabilities:
- Accounts Payable: £20,000
- Short-Term Debt: £15,000
- Accrued Liabilities: £10,000
- Taxes Payable: £5,000
= Total Current Liabilities: £50,000
The working capital ratio would be:
£100,000/ £50,000=2.0
A ratio of 2.0 indicates that the business has twice as many current assets as current liabilities, suggesting a healthy liquidity position.
What is a Good Working Capital Ratio?
A working capital ratio between 1.2 and 2.0 is generally considered healthy. Ratios below 1.0 indicate potential liquidity problems, as the business may struggle to meet its short-term obligations. Conversely, a ratio significantly higher than 2.0 might suggest that the business is not using its assets efficiently to generate growth, leaving too much liquidity unused.
Note, working capital ratio is not an absolute metric.
The ideal working capital ratio can vary by industry and the size of the business. For instance, industries with longer operational cycles might require higher ratios to ensure they can cover their longer cash conversion cycles. Small businesses should regularly benchmark their ratios against industry standards to maintain an optimal balance.
Improving Your Working Capital Ratio
A negative working capital ratio capital ratio is a red flag for costs outstripping revenue in the period under revenue. However, depending on the time frame you’re looking at, you may well have options for improving your ratio.
- Accelerate Receivables: If you’re waiting too long to get paid, this is a chance to implement stricter credit policies and follow up promptly on overdue accounts.
- Make the Most of Your Inventory: Unsold inventory is a sure way to limit your capital flexibility. Avoid overstocking and set benchmarks for how long you hold on to products to ensure you’re turning over goods at the right rate.
- Extend Payables if Possible: If you need more time to pay, you may have scope to negotiate longer payment terms with suppliers without harming relationships.
Common Mistakes and How to Avoid Them
Misinterpreting the Ratio
It’s important to avoid viewing the working capital ratio in isolation. Consider it alongside other financial metrics and qualitative factors like industry trends and business cycles to get a comprehensive picture of financial health.
Ignoring Industry Standards
Different industries have varying standards for what constitutes a healthy working capital ratio. Always benchmark against industry norms to ensure your business is on the right track.
Managing your Working Capital Smarter with iwoca
If you’ve got a looming gap in your working capital, a business loan from iwoca can help you access liquidity quickly and transparently. Whether you need to manage cash flow, invest in growth, or cover unexpected expenses, iwoca’s financing solutions can help you maintain a healthy working capital ratio.
- You can apply for a business loan online in minutes and get a decision quickly.
- Our process is designed to be hassle-free, with no paperwork and offers in as little as 24 hours.
- Once approved, you can start drawing down the funds you need.
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