Working capital is the money you have available to you to cover the day-to-day costs and requirements of operating your business, such as paying your employees or purchasing software, equipment, and supplies.
This ratio is crucial in a recession because it makes it possible to assess your business's financial health objectively.
How can you use this ratio to guide your judgments and where does it fit into that? The working capital ratio formula, its importance, how to calculate working capital, and what to do with the results are all covered in this article.
What is a Working Capital Ratio?
The ratio between your company's current assets and liabilities is known as your working capital ratio. It gives you a quick picture of how well your business is positioned to cover liabilities with its current assets as a measure.
As defined by law, assets are anything that a company holds that can fairly be converted into money (equipment, accounts receivables, intellectual property, etc.).
The company's debts are known as liabilities (loans, wages, accounts payable, etc.).
Why Does It Matter?
Working capital ratios are used by investors, accountants, and business owners to determine a company's readily accessible financial resources or available working capital.
It's a significant indicator since it can be used to determine the company's capacity to meet its immediate financial responsibilities, including paying employees, debts, and other payments.
As a business owner, it's important to you practically every day because it serves as an important gauge of the financial health of your organization. You can use this ratio to predict impending cash flow issues, even insolvency.
How Do You Calculate Your Working Capital Ratio?
Your working capital ratio formula is derived by dividing current liabilities by current assets, as opposed to the way working capital is calculated, which is to remove current liabilities from current assets:
CURRENT ASSETS divided by CURRENT LIABILITIES=WORKING CAPITAL RATIO
For instance, you can determine your working capital ratio by dividing your company's assets ($500,000) by its liabilities ($250,000). The ratio is 2.0 in this instance.
What’s a Healthy Working Capital Ratio?
A healthy working capital ratio formula falls between 1.2 and 2.0. You enter dangerous terrain known as negative working capital if it falls below 1.0. You would need to liquidate your current assets to cover your liabilities if you had more liabilities than assets.
Poor cash flow or ineffective asset management often leads to negative working capital. Your company may need to look into additional business funding if it needs more cash on hand to cover its debts.
Are you in the clear if your ratio is higher than 2.0? It takes a lot of work. Higher ratios don't automatically mean better results. Anything above 2.0 can be a sign that the company isn't making the best use of its resources. So, if growth is what you seek, pay attention.
What It Can Tell You
It's not always clear-cut how you interpret your working capital ratio, as it is with anything in accounting. Your industry, growth stage, and even seasonality effects all play a role.
Your ratio will change as your assets grow, for instance, if you have made some significant purchases or hired new employees to handle a contract with a significant new client.
You could see a false working capital ratio for a few months because assets can take some time to change. Although not always. Some businesses continuously have negative working capital (Amazon, Walmart, etc.). It isn't a problem, though, because they may swiftly turn their goods over or sell to clients before they have even paid for the merchandise.
The change in the working capital ratio can also be attributed to accounts receivable. Your assets will decline until the money is in the bank if you struggle with slow-paying customers or must give trade credit to remain competitive. As a result, you'll notice a realistically biased measure.
What is a good working capital ratio?
More cash is on hand when the ratio is higher, which is generally positive. A decrease in sales could result in a cash flow problem because a lower ratio indicates that cash is tighter.
Generally, a ratio of less than 1 can signify future liquidity issues, whereas one between 1.2 and 2 is excellent. If the ratio is excessively high (i.e., over 2), it can mean that the business is hoarding too much cash when, in reality, it might be reinvesting it to support growth.
Advantages of Working Capital
Revenue variations can be mitigated with the aid of working capital. Many companies have some seasonality in their revenue, for example, selling more in certain months than others.
A corporation can prepare for busy months by making additional purchases from suppliers if it has enough working capital, and it can also pay its bills in lean times.
For instance, a company might make 70% of its sales in November and December, but it still needs to pay for expenses like rent and employee salaries throughout the year.
The business may make sure it has enough money to stock up on supplies before November and hire temporary help for the busy season while making plans for how many permanent personnel it can support by evaluating its working capital needs and maintaining an acceptable buffer.
Positive vs Negative Working Capital
If a business has enough cash, accounts receivable, and other liquid assets to meet its short-term liabilities, including accounts payable and short-term debt, it has positive working capital.
In contrast, if a company doesn't have enough current assets to satisfy its immediate financial obligations, it has negative working capital.
A company with negative working capital could find it challenging to pay its creditors and suppliers and raise money to expand its operations. It might have to shut down ultimately if the scenario persists.
As a result, a shorter working capital cycle is advantageous for a company since it preserves the liquidity needed to operate the business.
In contrast, a larger working capital cycle strains a firm's balance sheet and has an impact on its liquidity.
Because short-term loans typically have higher interest rates, a firm may be forced to take them to meet its working capital needs if its working capital cycle is higher.
So, if all other KPIs are good, consider investing in businesses with shorter working capital cycles.
1. What is a working capital ratio?
To find the working capital ratio, divide the sum of current assets by current liabilities. It also goes by the name "current ratio" because of this. It is a metric for liquidity, which refers to the company's capacity to make payments as they become due.
2. Why is working capital calculated?
The discrepancy between current assets and liabilities is called working capital. It is a metric used in finance to determine if a business has enough liquid assets to cover its debts due in the next 12 months.
3. How do I calculate my working capital?
Subtract current liabilities from current assets to get a company's working capital. A corporation may satisfy its short-term obligations and carry on with daily operations if it has enough working capital.
4. Who defines working capital?
The total amount of cash and highly liquid investments that a business keeps on hand to cover day-to-day expenses is known as working capital. Technically, a company's working capital is determined by subtracting its entire current liabilities from its total current assets.
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