The working capital ratio and running a business
Businesses don’t go bankrupt just because they’re unprofitable. Most business failures occur because the company’s cash reserves have run out and they cannot meet their current payment obligations. An otherwise profitable business can also run out of cash flow due to the increasing capital requirements of new investments as they grow.
There are several helpful steps that can help a business avoid these pitfalls. Working capital refers to the difference between current assets and current liabilities of a business. The working capital ratio compares these figures as a percentage. Both measures can be useful in assessing the financial health of a business.
Key points to remember
- Working capital and the working capital ratio are both measures of a company’s current assets relative to its current liabilities.
- The working capital ratio is calculated by dividing current assets by current liabilities. This figure is useful for assessing the liquidity and operational efficiency of a company.
- A working capital ratio of less than one suggests that a business may be unable to pay short-term debts.
- Conversely, a very high working capital ratio suggests that a business is not effectively managing excess cash flow, which could be better geared towards business growth.
- Some analysts estimate the ideal working capital ratio to be between 1.5 and 2.0, but this can vary from industry to industry.
Use of working capital ratio
The working capital ratio reflects the operational efficiency of a company and the health of its finances in the short term. The working capital ratio is calculated by dividing the company’s current assets by its current liabilities:
Working capital ratio= Current liabilities Current assets
A high working capital ratio means that the company’s assets stay well ahead of its short-term debts. A low value for the working capital ratio, close to one or less, may indicate that the company may not have enough short-term assets to repay its short-term debt.
Most large projects require an investment in working capital, which reduces cash flow. Cash flow will also be reduced if money is collected too slowly, or if sales volumes decrease, resulting in lower accounts receivable. Companies that use their working capital inefficiently often try to increase their cash flow by squeezing suppliers and customers.
For example, if a business has $ 800,000 in current assets and $ 1,000,000 in current liabilities, its working capital ratio is 0.80. If a business has $ 800,000 in current assets and $ 800,000 in current liabilities, its working capital ratio is exactly 1.
Low working capital
If a company’s working capital ratio falls below one, it has negative cash flow, which means its current assets are lower than its liabilities. The company cannot cover its debts with its current working capital. In this situation, a business is likely to have difficulty repaying its creditors. If a business continues to have low working capital or if cash flow continues to decline, it can have serious financial problems. The cause of the decrease in working capital could be the result of several different factors including lower sales income, poor inventory management or problems with accounts receivable.
High working capital
Excessively high working capital isn’t necessarily a good thing either, as it can indicate that the business is letting excess cash flow rest rather than effectively reinvesting it in growing the business. Most analysts consider the ideal working capital ratio to be between 1.5 and 2. As with other performance measures, it is important to compare the ratio of a company to that of similar companies within its industry.