How to Calculate Working Capital Ratio

Your working capital indicates how much money you have to work with between your current assets and liabilities. But to know your business’ true financial health and liquidity status, you need to know your working capital ratio.

Do you know how to calculate your working capital ratio, and why it’s so important for your business? What is an ideal ratio and what to do to reach it?

Read on for the answers to these questions and much more.

What is Working Capital Ratio?

Working capital, or net working capital, is the difference between the current assets and current liabilities on a company’s balance sheet. It indicates short-term financial health and liquidity.

The working capital ratio is the liquidity equation. It determines the business’s ability to pay off current liabilities with available current assets. Once you understand what to look at, calculating it is quite simple.

How to Calculate Working Capital Ratio (WCR)

The current assets typically included in the calculation include:

• Accounts receivable/customers’ unpaid bills
• Cash
• Inventories – raw materials and finished goods

Current liabilities usually included in the calculation are:

• Accounts payable
• Debts

The Formula for Working Capital Ratio

Here is the basic working capital ratio calculation: WCR = Current Assets ÷ Current Liabilities

The current ratio is calculated by dividing the current or short-term assets by the current liabilities or short-term financial obligations.

Why Does the WCR Matter?

Showcases a Company’s Financial Health

When you know your WCR, you will have a clearer idea of your business’s financial health and liquidity. This will make it easier to make profitable business decisions. It will also improve your standing in business partnership negotiations.

Highlights Opportunities for Expansion

A higher WCR may indicate inadequate use of available funds. If you have excess or idle funds, you’ll know to start utilizing them more effectively. This can mean expanding the business, growing your team,  or investing in more stock.

Indicates Where Improvements Need to Be Made

A lower WCR may indicate financial difficulty and the inability to pay banks, vendors, and other creditors. This is an opportunity to address these issues, either with renegotiated vendor agreements or restructured/refinanced loans.

What Is a Good Working Capital Ratio?

How much working capital do you need to meet your payment obligations? Our research shows that a ratio of approximately 1.2 to 1.8 is considered a healthy, balanced ratio. For many, an ideal working capital ratio is closer to 2, as this indicates that the business can meet its financial obligations.

However, a ratio that is less than 1 can spell bad news for the company. This shows a negative working capital situation and indicates that the business is not financially healthy. Therefore, it is unable to meet its financial obligations and cannot afford to pay its current liabilities.

Is a High Working Capital Ratio Good?

A negative working capital ratio of less than 1 means your business may be in difficulty. If such a negative ratio continues, bankruptcy may be in the future.

Because a balanced working capital ratio closer to 2 is good, you may think a higher working capital ratio (above 2) is even better. But that is not necessarily true: a very high working capital ratio is a sign of excess and idle funds. It shows the business’s funds are not being adequately utilized.

How to Improve Net Working Capital Ratio

The difference between your current assets and current liabilities establishes whether or not you have a good or bad WCR. But there are a few things you can do to improve it.

Ensure More Accurate Accounts Receivable Numbers

Money coming into your business increases your company’s working capital. Accounts receivable are the funds you expect to receive from customers. Designated as current assets, they raise your WCR. But this is only useful if customers will pay what they owe you.

Enhance your screening of customers to determine who is a good candidate for a credit line. And improve your follow-up for unpaid accounts. Consider offering a discount for full settlement, or a cash payment. This will improve the odds of receiving what is due to you, and ensure more accurate WCR calculations.

Increase Your Inventory Turnover to Increase Cash Flow

Your inventory, the items you intend to sell in the next year or less, are current assets. Proceeds from sales increase working capital and improve your WCR. Of course, if you run a service-oriented business, this may not be a factor. But in a sales-oriented business, it matters a great deal.

Calculate your inventory turnover, and make any necessary changes to your inventory management. This will allow you to have enough of the type of stock that sells more, leading to an improved cash conversion cycle, with more potential sales, and working capital.

Reduce or Refinance Your Debt

Reducing or refinancing your debt reduces your current liabilities. This will have a positive effect on your WCR. We recommend that you research your loan options, to find more suitable terms or lower interest rates.

Take Out a Working Capital Loan

A working capital loan provides quick access to funding that covers short-term operational needs. It can improve your working capital cycle, and enable you to get your business back on track. If most of your business transactions are done through Paypal, you may qualify for a Paypal Working Capital Loan.

What Does The Working Capital Ratio Suggest About Liquidity?

A company’s liquidity is its ability to pay off its short-term liabilities (due in less than a year). The working capital ratio is, ultimately, a liquidity equation. It highlights a business’s economic health, and ability (or non-ability) to meet its financial obligations.

By doing the WCR calculation, you can determine your own business’s liquidity. If the result is low, take some of the steps above to increase your working capital and improve the ratio. If it is too high, consider making better use of your available funds by scaling up or expanding your inventory line.

How Does It Differ From Working Capital, Free Cash Flow, and Cash Flow?

To answer this, let’s look at what the terms cash flow, free cash flow, and working capital mean.

• Cash flow is the movement of money into and out of a company over a certain period. When the inflow exceeds the outflow, the cash flow is said to be positive.
• Free cash flow is, as the name suggests, the cash that remains free after capital expenditures and operating expenses. It excludes non-cash expenses from the income statement.
• Working capital is the difference between a company’s current liabilities and current assets.

Therefore, a working capital ratio is a liquidity calculation. While working capital shows the difference between liabilities and assets, the WCR shows the ability to pay off those liabilities with those assets.

Conclusion

A working capital ratio is an equation that expands on your knowledge of your working capital. It is a simple way to better understand your financial health. When you know how to calculate it, and what to do to improve it, you can take steps to enhance your business’s liquidity.

One of the best ways is to take a working capital loan. At E-Boost Partners, we help small businesses access various types of short-term loans to ensure a positive working capital ratio and more growth opportunities. Contact us today for more information.