You’ve probably heard “cash is king” at some point. A strong cash position is certainly important to small businesses.
With that said, your working capital – which is your current assets (e.g., cash, accounts receivable, and inventory) minus current liabilities (e.g., accounts payable, wages payable, and short-term debts) – is arguably a better measure of your ability to meet your short-term financial obligations.
A good amount of working capital varies depending on the size of your business, so we recommend using working capital ratio to determine the health of your small business.
In this article, you’ll learn:
- Working capital ratio meaning
- What a good working capital ratio is
- Other ways to measure your ability to cover short-term obligations
- How to improve your working capital ratio
What is the Working Capital Ratio?
Working capital ratio – aka the current ratio – is calculated by dividing current assets by current liabilities.
A working capital ratio above one means that a company has enough current assets (assets that can be turned into cash within a year) to cover its current liabilities (liabilities that have to be paid within a year).
But if you have a working capital ratio below one – which means you have negative working capital – you may not be able to cover your short-term debts.
So, working capital ratio above one = good and working capital ratio below one = bad?
Not exactly.
But it’s not hard to determine a good working capital ratio for your small business.
What is a Good Working Capital Ratio?
For many small businesses, a working capital ratio between 1.5 and 2 is ideal.
Again, you don’t want your working capital to be too low, as you may be unable to meet your short-term obligations in that case.
But you may be wondering: is there anything wrong with a really high working capital ratio?
Actually, there is.
If you have more working capital than necessary, it means you have excess cash that could be used to grow your small business or invest in assets unrelated to your business (e.g., stocks, bonds, and real estate). By letting that excess cash sit on your balance sheet, you earn no return – and arguably, a negative return due to inflation.
Next, let’s look at a few factors that affect the ideal working capital ratio for your small business.
Inventory
Some small businesses need to keep a lot of physical inventory (e.g., retailer) on hand, while others don’t (e.g., SaaS). You can’t liquidate your inventory whenever you want – unless you’re willing to sell at a huge discount – so you shouldn’t rely on your inventory to cover short-term financial obligations.
With this in mind, the more physical inventory is required to run your business, the higher your ideal working capital ratio.
In addition, you may need more inventory during the holiday season, so it’s important to be aware of your seasonal working capital.
When You Bill Customers
Do you bill your customers upfront or after providing goods or services? The answer to this question impacts your accounts receivable… which impacts your working capital.
If you bill after providing goods or services, your working capital needs are going to be higher than a company that bills upfront. That’s because a late payment would jeopardize your ability to cover short-term financial obligations if you don’t have any margin of error.
State of the Economy
During an economic downturn, it may take longer for you to collect accounts receivable and liquidate inventory. At the same time, your lenders and suppliers may offer you less attractive terms.
So, you get hit on the current assets and current liabilities parts of the working capital equation.
If you don’t have enough working capital, you may be forced to sell your inventory or invoices at a discount. Or you may have to quickly borrow money from a lender – which may result in you getting bad terms (remember, this is during a recession).
Bottom line: if the economy is looking shaky, make sure you have enough working capital.
Other Ways to Measure Ability to Meet Short-Term Obligations
While working capital ratio is a very useful tool for determining the financial health of your small business, it isn’t the be-all, end-all.
As you saw earlier, one of the limitations of working capital is that all current assets are counted the same.
Let’s say two companies have the same working capital ratio.
For Company A, current assets consist of 40% inventory, 40% accounts receivable, and 20% cash. For Company B, current assets consist of 80% cash, 10% inventory, and 10% accounts receivable.
Company B is in a stronger financial position – all other things being equal – because inventory and accounts receivable can’t be predictably turned into cash (which is needed to cover short-term financial obligations).
The quick ratio and cash ratio are two more ways to determine your ability to cover short-term debts.
As a small business owner, you should look at a number of metrics before making key financial decisions, as there is no single metric that gives you the full picture of your small business’s financial health.
How to Improve Your Working Capital Ratio
The two ways to improve your working capital ratio are increasing your current assets or decreasing your current liabilities.
You can increase your current assets by increasing your operating cash flow and putting the extra cash in the bank. You can reduce your current liabilities by paying them off, or pushing them into the future (beyond a year out).
Need Cash to Cover Short-Term Financial Obligations?
Are you struggling to cover your short-term debts?
If so, you can get some breathing room with Gravity Capital.
Get quick funding, and repay the funds with the ebbs and flows of your small business.
Learn more about how Gravity Capital can help your small business or get familiar with more financial ratios.
