The principal idea of a successful business boils down to two key metrics – profitability and liquidity. Generally, businesses don’t go bust because they aren’t profitable – rather, they go bankrupt because they are out of cash.
A healthy business is one that has enough positive cash flow to meet all of their financial obligations to creditors and all other business expenses as they come in, without having to rely heavily on bank loans that may come with exorbitant interest rates that affect financial health in the long run.
Working capital is the term used to describe the available money that a business has on hand in order to support all activities and operations happening in the short term. Unlike long-term investments such as fixed assets and R&D, having enough working capital is the key to running a business smoothly.
In short, the more cash a business has on hand to cope with expenses, the better it can be run, and a well-run business always has a higher potential for profitability as compared to those that have less ability to pay off their debts.
What is the formula for working capital ratio?
In order to measure the amount of working capital in your business, you need to calculate your working capital ratio. This ratio basically defines the financial health and liquidity of your business when it comes to handling day-to-day operations. Here’s the formula of working capital:
Current assets / Current liabilities = Working Capital Ratio
This formula involves a little research into your business assets and liabilities. Generally, a higher working capital ratio number means you have greater flexibility in your operations – you can either choose to expand or invest in other bolt-on ventures related to your business. A ratio of 1:1 is a common figure – this means that the business is not in the red, neither is it swimming in cash – however, its day-to-day operations are running smoothly.
Anything less than 1:1 represents a negative working capital, which means that the business is probably finding it hard to cope with expenses such as bills, creditors and the like. A ratio of 2:1 on the other hand, is usually a comfortable level that means cash flow is safe, and the business is reasonably profitable.
It is also worth remembering that this ratio is also dependent on the operating cycle of your business. The business operating cycle is the amount of time it takes for your business to sell inventory and collect any accounts receivable. The general idea is that businesses with longer operating cycles require a higher working capital ratio than businesses with shorter cycles in order to be regarded as comfortable.
Is working capital ratio same as current ratio?
Yes. Working capital ratio is by definition, a measure of the liquidity of a business that gives it the ability to meet all its payment obligations as they fall due. Current ratio means exactly the same thing – both terms can be used interchangeably.
Any company that does not meet its current financial obligations is at risk of having to file for bankruptcy – no matter how rosy their prospects for future growth may be. Liquidity basically represents how much a business has in legally owned assets that it can sell off for cash to satisfy all of its liabilities and pay off its creditors.
However, liquidity does not represent the additional financing methods that a company may have available – this could be unused credit lines, loans or other short-term financing that involves borrowing from financial institutions or other related individuals.
The working capital ratio is a useful way to take stock of all these factors and turn it into a quantifiable figure that can be used to represent the current financial health of a business in order to help its owners or stakeholders make decisions that affect the business in the long-term.
Is high or low working capital good?
To put it simply, a higher working capital ratio is an ideal situation to have as compared to a lower one. A lower working capital ratio means that your current liabilities (what you have to pay out) are weighing heavier than your current assets (what you own or are due to receive) – making it difficult for you to expand your business past the day-to-day operations.
However, a significantly higher ratio may potentially indicate that the business is not utilizing its assets to generate the maximum possible amount of revenue it can get – after all, the whole point of business is to put in money in order to see it grow and increase in profitability.
Disproportionate working capital ratio figures like these are reflected in an unfavorable return on assets (ROA) ratio, which is used to evaluate the profitability of a company.
Common drivers used to forecast working capital ratio
As with all other aspects of business, forecasting your work capital is a good way to establish the steps that you as a business owner can take moving forward in order to assess and mitigate risks that may jeopardize the long-term financial health of your business.
Here are some common drivers that are found in financial models used to forecast the working capital ratio of a business:
- Inventory days
Inventory days is an efficiency ratio that refers to the number of days it takes for a business to sell off the stock to customers. In other words, it represents how fast a business can make money from its goods or services without having cash tied up in stock for the long-term.
- Accounts receivable
This refers to the money that a business’ clients or customers owe it for goods or services delivered but agreed upon to pay at a later date. It is listed in a business balance sheet as a current asset.
- Current assets
Current assets are defined as cash or other assets owned by a business that can be expected to be converted into cash within a 12-month period.
- Accounts payable
As opposed to accounts receivable, accounts payable refers to the monetary debts that a business owes its creditors and has yet to pay off.
- Current liabilities
Current liabilities refer to the short-term financial obligations of a business that are due within a 12-month period. This includes accounts payable, short-term debt, shareholder dividends, and any business-related taxes owed.