As a small-business owner, it’s important for you to keep an eye on the short-term financial health of your company, because short-term challenges can turn into long-term issues. So how do you get an accurate picture of your company’s financial health? A great way to get a quick snapshot of short-term financial health and the efficiency of your company is by calculating working capital and the working capital ratio.
What is Working Capital?
Working capital measures how well your company is doing financially by comparing your current assets to your current liabilities. Think of it as an indicator of the amount of cash and liquid assets, or assets, you can quickly convert to cash when you have available to meet your current financial obligations.
Working Capital and the Working Capital Ratio
Working capital ratio is a basic measure of liquidity that shows the ability of your 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 your company has $500,000 in current assets and $200,000 in current liabilities, your 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 2.5:1.
So what number should you strive for as your working capital ratio? That depends on how much of a safety net you want in your business. An ideal working capital ratio to strive for is 2:1, as it gives you a comfortable cushion without leaving too much capital underused. You may consider aiming for a higher ratio just to be safe, but more isn’t always better. If your ratio is higher, that may indicate that you’re letting too much capital sit around instead of investing it in the growth of your business.
Working capital ratios lower than 1:1 mean that your company has negative working capital and needs to make improvements. When your ratio is lower than 1:1, your company has more current liabilities than current assets. This signals that your business will likely experience liquidity problems in the near future.
Analyzing Trends with Working Capital Ratios
An example of how the working capital ratio changes over time can help you see how monitoring this ratio can help you identify trends in your business. Assume you’ve gathered financial data about your company for the past three years.
- Year 1: Current assets = $100,000 and current liabilities = $50,000
- Year 2: Current assets = $150,000 and current liabilities = $120,000
- Year 3: Current assets = $180,000 and current liabilities = $180,000
At first glance, by looking at your current assets, you can see that your company is growing. In this three-year period, you have nearly doubled your current assets. But you can see that the liabilities grew, too. The working capital ratio can be a useful tool in this situation to get a clearer picture. You calculate the ratio for the three years as follows:
- Year 1: Working capital ratio = $100,000 / $50,000 = 2:1
- Year 2: Working capital ratio = $150,000 / $120,000 = 1.25:1
- Year 3: Working capital ratio = $180,000 / $180,000 = 1:1
The trend of your business is now clearer. Your company is growing – but at the expense of current liabilities that may be too high and create issues for cash flow later on.
The first year the company was strong with a working capital ratio of 2:1, but by year three, you’re in a situation where the working capital ratio is only 1:1.
If the trend continues, you can face a negative working capital in year four, and you could begin experiencing liquidity problems. It might be time to make some serious changes in the way your business operates.
Working capital ratio is a simple tool that any business owner can use to quickly see the short-term financial strength of their company.
A value below 1:1 is problematic and signals that operations in the company must change. A value around 2:1 is typically considered strong, and higher values indicate that you might benefit by reinvesting some of that working capital into your business.
As a small-business owner, you always want a clear snapshot of your company’s health at any point and over the long run. Improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.