Before sharing a working capital ratio definition, it seems essential to remind what working capital is. It’s the amount of money you need in order to support your short-term business operations. It’s the difference between current assets (such as cash and inventories) and current liabilities (such as a bank credit line or accounts payable).
Now, what is the working capital ratio? It is a measure of , calculated simply by dividing your business’s total current assets by its total current liabilities. In other words, it measures the health of your company’s short term finances.
The working capital ratio is sometimes referred to as the current ratio as the measure is generally calculated quarterly, that is, on a “current” short-term basis.
So there is no difference between current ratio and working capital ratio.
The working capital ratio (or “current ratio”) formula is:
Working capital ratio = current assets/current liabilities
This current ratio shows how much of your business revenue must be used to meet payment obligations as they fall due. And, as a consequence, it shows you how much you have left to use for new opportunities such as expansion or capital investment. Therefore, it is important to know how to improve the working capital ratio.
A good working capital ratio (remember, there is no difference between current ratio and working capital ratio) is considered to be between 1.5 and 2, and suggests a company is on solid ground. In the best sense, it indicates you have enough money on-hand (e.g. your customers have paid you on time, you have funds in the bank or access to financing) to pay your suppliers or your lease or employees without difficulty.
A ratio greater than 3 suggests a company may not be using its assets effectively to generate future growth. Your money should be working for you as hard as your employees are. For example, developing new products and services, looking for new markets, planning ahead to remain competitive.
If the working capital ratio calculation shows your company's current liabilities exceed its current assets – for example, if your working capital ratio turns out to be less than 1 -- your company has a negative working capital ratio. In other words, there is more short-term debt than there are short-term assets on your balance sheet, and you’re probably worrying about meeting your payroll each month.
Take this as a sign you should be increasing revenues or cutting expenses – or both – to avoid liquidity problems. You need to see how to improve your working capital ratio. Review where you can cut back, and remember: if you choose to produce more in order to increase revenues, this increased production will cost more money, whether it’s overtime for your sales staff or an extra shift for your employees.
You should also seek outside sources of funding, and have a look at your billing cycle and customer payments. For example, if one of your major customers pays you on a quarterly basis, you may have difficulties meeting monthly bills. You might suggest : can you receive a portion of the amount due up-front? Or ask for a letter of credit to use as short-term funding collateral?
An exception to this is when negative working capital arises in businesses that generate cash very quickly and can sell products to their customers before paying their suppliers.
Figuring out a good working capital ratio and then keeping an eye on your company’s can help you understand when a shortfall lies ahead so you can take the necessary steps to maintain liquidity. Knowing how to improve your working capital ratio will give you the resources you need to take advantage of new business opportunities.
There are a number of ways to boost working capital to ensure you avoid a negative working capital ratio. For example:
- Create a shorter operating cycle to increase cash flow and reduce the possibilities of non-payment. If you are in the position of having to pay suppliers before receiving payments yourself, you may be forced to use your accounts receivable as a form of collateral for financing an increase in working capital to cover the gap. A shorter operating cycle combined with can be a less expensive option.
- When taking on new clients, don’t forget to conduct customer credit checks. You want to be sure the new business will increase your revenues and safeguard your working capital.
- Avoid financing fixed assets with working capital, such as IT equipment. Lease or take out a long-term loan instead of depleting your company’s cash.
- Consider buying trade credit insurance. By insuring your business from non-payment of your accounts receivable, trade credit insurance helps keep your working capital ratio at an adequate level and supports your application for financing because lenders consider it as secured collateral.
Remember: working capital is important in each step of your business cycle, from the purchase of materials and production of goods or services, to sales and receipt of payment. And improving your working capital ratio means you can seize growth and new business opportunities.