Working Capital Ratio: What Is Considered a Good Ratio?

working capital ratio

The working capital requirement of your business is the money you need to cover this time delay, and the amount of working capital required will vary depending on your business and its needs. The shows the ratio of assets to liabilities, i.e. how many times a company can pay off its current liabilities with its current assets. The Working Capital is a specific subset of balance sheet items, and calculated by subtracting current liabilities from current assets. In its simplest form, working capital is just the difference between current assets and current liabilities. However, there are many different types of working capital that each may be important to a company to best understand its short-term needs.

It is a measure of a company’s liquidity and its ability to meet short-term obligations, as well as fund operations of the business. The ideal position is to have more current assets than current liabilities and thus have a positive net working capital balance. It provides valuable insights into a company’s financial health and its capacity to meet its short-term liabilities with its current assets. Calculating this ratio is essential for understanding a company’s financial stability and making informed investment or lending decisions. Working capital is also a measure of a company’s operational efficiency and short-term financial health. If a company has substantial positive NWC, then it could have the potential to invest in expansion and grow the company.

How do you increase your working capital?

It gives you greater flexibility in your cash flow by giving you up to 54 days to clear the balance¹. Plus, each £1 you spend earns you 1 Membership Rewards® point that you can redeem with hundreds of retailers on items such as office supplies, IT equipment or employee perks². Working capital is the money a business can quickly tap into to meet day-to-day financial obligations such as salaries, rent, and office overheads. Tracking it is key since you need to know that you have enough cash at your fingertips to cover your costs and drive your business forwards. A good rule of thumb is that a net working capital ratio of 1.5 to 2.0 is considered optimal and shows your business is better able to pay off its current liabilities.

An otherwise profitable company may also run out of cash because of the increasing capital requirements of new investments as they grow. Working capital (as current assets) cannot be depreciated the way long-term, fixed assets are. Certain working capital, such as inventory, may lose value or even be written off, but that isn’t recorded as depreciation.

Example of Working Capital Turnover

With $1.70 of current assets available for every $1 of current liabilities, ABC Co. has a healthy working capital ratio. The latter objective can be achieved by doing the same on the accounts payable side of operations. That involves renegotiating payment terms with suppliers to extend the amount of time you have to pay debts, using dynamic discounting or supply chain finance, and streamlining accounts payable processes. This time delay between when your business pays money out (e.g. to suppliers) and when it receives money back (e.g. from sales) is known as the working capital or operating cycle.

We can see in the chart below that Coca-Cola’s working capital, as shown by the current ratio, has improved steadily over the last few years. If a company is fully operating, it’s likely that several—if not most—current asset and current liability accounts will change. Therefore, by the time financial information is accumulated, it’s likely that the working capital position of the company has already changed. If the working capital turnover ratio is high, it means that the business is running smoothly and requires little or no additional funding to continue operations. It also means that there is robust cash flow, ensuring that the business has the flexibility to spend capital on inventory or expansion. Since the turnover ratio is high, it shows that the company’s management is effective in utilizing the company’s short-term liabilities and assets to support sales.

Operating Working Capital Formula

This means the company does not have enough resources in the short-term to pay off its debts, and it must get creative in finding a way to make sure it can pay its short-term bills on time. A short-period of negative working capital may not be an issue depending on a company’s place in its business life cycle and if it is able to generate cash quickly to pay off debts. When a working capital calculation is negative, this means the company’s current assets are not enough to pay for all of its current liabilities. Negative working capital is an indicator of poor short-term health, low liquidity, and potential problems paying its debt obligations as they become due. When a company does not have enough working capital to cover its obligations, financial insolvency can result and lead to legal troubles, liquidation of assets, and potential bankruptcy.

  • To calculate your working capital requirements, use the projected increase in your sales to estimate how much cash you will need to cover your additional outlays on inventory, accounts payable and accounts receivable.
  • A lower ratio means cash is tighter, so a slowdown in sales could cause a cash-flow issue.
  • Businesses with seasonal demands require additional working capital, usually on a temporary basis when customer demand is high.
  • A positive number means you have enough cash to cover short-term expenses and debts, whereas a negative number means you’re struggling to make ends meet.
  • However, in reality, it’s rare that you are able to access your revenue before you need to pay your bills.