Why is my business' working capital ratio important?

Profitable businesses can fail when they don't have enough cash to afford their day-to-day expenses. Sometimes, it even happens to businesses right when they get a big break. Their product is taking off, orders are flowing in, but they start struggling to afford supplies and payroll when large clients take months to pay invoices.

Answering the question of "why is working capital important - the assets you have to run the business - is essential if you want to meet your short- and long-term goals. And your working capital ratio could help you determine if you'll soon be dealing with a cash-flow crunch that threatens your business.

What is working capital?

Working capital is an accounting term that's related to a business's short-term financial standing. It takes into account the cash you have in the bank, along with other types of assets that you could quickly sell, and compares these assets to your business's short-term liabilities.

To determine what your working capital is, the formula is:

Net working capital = current assets - current liabilities

A business's current assets and liabilities are listed on its balance sheet. Assets and liabilities are generally considered current if you expect to use the asset or pay the liability within the next 12 months.

• Current assets include: Cash, accounts receivable, short-term investments, inventory, and office supplies. Prepaid expenses, such as when you pay the annual premium for an insurance policy, are also included in current assets.
• Current liabilities include: Accounts payable, wages, taxes, interest payments, and the current portion of long-term debts. For example, if you took out a five-year $25,000 loan, only the portion of the loan that you'll need to repay in the following 12 months gets included in current liabilities.

Why is working capital important?

Knowing what is your working capital is important because it can help you understand your financial position. For example, if you have $150,000 in current assets and $100,000 in current liabilities, you'll have $50,000 in working capital to cover unexpected expenses. Or, you could use the money to invest in your company knowing that you'll still have enough assets to cover your liabilities.

How to calculate your working capital ratio

You can also use the current assets and liabilities from your balance sheet to calculate your working capital ratio, which is sometimes shortened to current ratio.

Working capital ratio = current assets / current liabilities

What is a working capital ratio? Well, it is a ratio that will show you the relationship between your assets and liabilities regardless of the size of your business. A business with $150,000 in current assets and $100,000 in current liabilities has a working capital ratio of 1.5, as does a business with $1.5 million in assets and $1 million in liabilities.

Tracking what the working capital ratio is over time can give you greater insight into your business's financial health. In part, this is because your net working capital needs may grow with your business, but your target working capital ratio could stay the same.

What is a good working capital ratio?

Your target working capital ratio can depend on your business, industry, and what stage of business you're in (e.g., growth versus maturity).

For example, a business that has a sophisticated inventory management system and quick product turnover might have a low working capital ratio because it doesn't keep much inventory on hand (a potentially large source of current assets).

However, in general:

• A working capital ratio of one indicates you have enough assets to cover your liabilities, but nothing leftover. You'll want to keep a close eye on your cash flow in case you wind up with more liabilities than assets. Also, even if your finances work on paper, you might want to try and increase your working capital to avoid having to sell non-cash assets to pay upcoming bills.
• A working capital ratio higher than one indicates your business has enough money to pay its bills and then some. It's a sign that the business is financially healthy, at least in the short-term. One of the additional reasons why working capital is important and the significance of a healthy working capital ratio is that it may even have money available to invest in long-term capital assets and growth opportunities.
• A working capital ratio lower than one is a potentially worrying sign. It means that your business can't cover all of its short-term liabilities with its assets and may need to borrow money to pay for day-to-day operations. A lack of working capital could hinder your company's growth or lead to its eventual demise.

There's no perfect ratio for all businesses

You may need to do more research on your particular industry, talk to other small business owners who run similar businesses, or speak with your accountant to get a better understanding of what is your target working capital ratio.

A 1:1 ratio is probably too tight for many small businesses. But you also don't want the ratio to be too high, as that could indicate you aren't wisely using your available cash and should be looking for ways to put the money to work.

Additionally, tracking what the working capital ratio is over time can give you additional insights. If the ratio is trending down, you may soon be faced with a short-term liquidity crisis as you scrabble to afford your bills.

On the other hand, if it's trending up, you might feel more comfortable giving your top performers a raise, buying equipment, or investing in the business's growth.

Why finding additional working capital can be important

Lack of working capital can become an issue whether you're facing a great opportunity (but lack the cash to accept) or struggling to afford your operational expenses. Sometimes, a working capital loan is the best way to get a quick cash infusion and improve your working capital ratio.