It’s important for a small business owners to keep an eye on the short-term financial health of their companies since problems in this area can be disastrous, even leading to the business closing permanently. Great ways to get a quick snapshot of short-term financial health and efficiency of the company is by calculating working capital and the working capital ratio.
Working Capital and the Working Capital Ratio
Working capital is a basic measure of liquidity that shows the ability of a company to meet its current financial obligations and remain solvent. You calculate it by taking the company’s current assets and subtracting its current liabilities. If a company has $500,000 in current assets and $200,000 in current liabilities, its working capital is $300,000. The working capital ratio is simply the company’s current assets divided by its current liabilities (this is also know as the current ratio). In this example, the working capital ratio is $500,000 divided by $200,000, which is 2.5.
Even in the same industry, companies can have very different working capital ratios. Generally speaking, there are some values of the working capital ratio that are accepted as good and bad. Working capital ratios lower than 1 mean that the company has negative working capital. In other words, the company has more current liabilities than current assets. This signals that the company will likely experience liquidity problems in the near future. A working capital ratio of about 1.5 to 2 is considered good. It shows that the company is financially healthy and efficiently managing its resources. A value higher than 2 is not necessarily better. This demonstrates that the company is likely not generating as much revenue as possible by intelligently employing all of its assets.
Analyzing the Trend in Working Capital Ratio
Assume a company has gathered financial data on itself for the past three years.
- Year 1: Current Assets = $1M, Current Liabilities = $500,000
- Year 2: Current Assets = $1.5M, Current Liabilities = $1.2M
- Year 3: Current Assets = $1.8M, Current Liabilities = $1.8M
At first glance, by looking at the current assets, you can see that the company appears to be growing. In the three-year period it has nearly doubled its current assets. But you can easily see that the liabilities grew, too. The working capital ratio can be a useful tool in this situation to get a clearer picture. The ratio for the three years is calculated as follows:
- Year 1: Working Capital Ratio = $1M / $500,000 = 2
- Year 2: Working Capital Ratio = $1.5M / $1.2M = 1.25
- Year 3: Working Capital Ratio = $1.8M / $1.8M = 1
The trend of this business is now clearer. It is growing but at the expense of current liabilities that may be spiraling out of control. The first year the company was strong with a working capital ratio of 2, but by year three, the company is in a situation where the working capital ratio is only 1. If the trend continues, working capital will be negative in year four, and the company will begin experiencing liquidity problems. The downfall of the company might be right around the corner unless management makes some serious changes in the way the business operates.
Working capital is a simple tool that any business owner can use to quickly see the short-term financial strength of their company. A value below 1 is problematic and signals that operations in the company must change. A value between 1.5 and 2 is typically considered strong, and higher values indicate that management needs to utilize the company’s resources in a more efficient way.