Every business record high and low moments, sometimes alternately depending on the seasons. There will be bumper periods when profits trickle in fast and furious and days when revenue generation nearly grinds to a halt.
As an astute businessperson, it’s important to stay on top of your company’s performance to make financially sound, data-driven decisions.
Fortunately, there are several useful metrics you can rely on to gauge your business’ profitability and liquidity. One such yardstick is the working capital ratio.
Here’s everything you need to know about the working capital ratio and what it says about your business’ health.
The working capital ratio compares the difference between a business’s current assets and current liabilities. It’s commonly expressed as a ratio, decimal, or percentage.
The formula for computing the working capital ratio is as follows;
WCR = CA/CL, where the initials represent the working capital ratio, current assets, and current liabilities, respectively.
Current assets refer to short-term assets. They include cash and cash equivalents that a business can liquidate within a year or during its current accounting period. Accounts receivables and stocks are noteworthy examples of current assets.
Similarly, current liabilities are liabilities that a company expects to be settled in a year or within its current accounting period. Examples include accounts payables and short-term loans.
Like most metrics used to assess a company’s health, working capital ratio can be greater than one, less than one, or equal to one. As you’re about to discover, each ratio speaks volumes about your company’s profitability.
Both working capital and working capital ratio are critical in determining a company’s profitability. However, the two terms differ slightly in meaning and implication.
Working capital is the difference between current assets and liabilities, whereas the working capital ratio compares those differences.
Assume your company has $1 million of current assets and $900,000 in current liabilities.
Using the above formula, you can compute the working capital as $1,000,000 - $500,000 = $500,000.
The working capital ratio would be $1,000,000/$800,000 = 10:8. You can also express this ratio as a decimal (1.25) or percentage (125%).
A working capital ratio of less than one means that your current assets are lower than your current liabilities. In other words, your business is on a loss-making streak, and you’re unable to cover your debts.
A negative working capital can greatly blow your cash flow if it goes unmitigated long enough. It could also cause you to lose reliable suppliers, employees, and other stakeholders, eventually grinding your company to a halt.
The best way to fix a negative working capital ratio is to re-energize your marketing efforts and stimulate more demand for your products. Other interventions include invoice factoring to reduce accounts receivables and procuring a short-term business loan to consolidate debts.
If your company’s working capital ratio equals one, it means the value of its current assets is exactly similar to its current liabilities. This asset-liability equilibrium further implies that your business is neither generating profits nor making losses.
A working capital ratio of 1 is generally undesirable. One wrong move can cause the balance to tilt in the wrong direction.
However, a working capital ratio equal to one may provide temporary relief if your company has just emerged from a loss-making streak.
Every entrepreneur desires a positive working capital ratio. It’s the surest indication that your business is generating adequate profits to meet its current liabilities.
However, beware of an excessively high working capital ratio, as it indicates an unusual value of liquid assets lying idle in your company. Idle assets tend to lose value unless plowed back into the business or invested in other income-generating ventures.
While there’s no consensus on the ideal working capital ratio, most analysts consider a range between 1.2 and 2.0 to be safe.
Working capital ratio is a reliable metric for assessing a business’ health. It’s particularly important in analyzing a company’s profitability and liquidity.
However, the working capital ratio isn’t restricted to the corporate and entrepreneurial landscapes. You can also leverage the concept to understand your individual cost of living better and make the necessary adjustments.
A working capital ratio less than or equal to zero may indicate that a significant percentage of your earnings goes into servicing debts. It also suggests you could be living above your means.
Each industry is unique. Therefore, what many experts consider the ideal working capital ratio may not always apply across the board.
For instance, a business might report a negative WCR right after procuring a huge loan. That doesn’t necessarily speak to the company’s inability to cover its debts, especially if it can still manage its cash flow effectively.
Similarly, a business may report a high working capital ratio after having most of its accounts receivables settled concurrently. These exceptional circumstances do not paint a clearer picture of a company’s finances.
Understanding the concept of working capital is critical to unlocking growth in your company. While profits are bound to fluctuate depending on the economic times and the seasons, strive to keep your working capital ratio between 1.2 and 2.0 as much as possible.