Working capital is the most relevant indicator in terms of a company’s short-term financial health. A higher working capital ratio means that the company has the money to invest and expand, at least on a 12 month time horizon. It is a significant measure of operational efficiency.
On the other hand, if a company has a low or negative working capital ratio, it is an extremely bad sign. This is because it will be unable to pay back creditors or purchase new stock and inventory. The interest on loans will accrue and it could even go bankrupt.
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A Closer Look at Working Capital
Working capital is the amount of liquidity a business or company has for its operations. Working capital is expressed as a ratio, and the higher, the better! Working capital is sometimes referred to as ‘Net Working Capital’ (‘NWC’), though this refers to an absolute figure, not a ratio.
Along with fixed assets, working capital is part of what is termed ‘operating capital’. The primary difference is that working capital is capital at hand (such as cash) to cover working expenses. Fixed assets, in contrast, are more difficult to liquidate.
This is why working capital is such an important metric for business viability. It is one of the first things a potential investor or business partner will want to see. Below, we’ve explained how to calculate working capital, a relatively simple formula.
Formula to Calculate Working Capital
The formula for calculating working capital is as follows:
The Current Assets of a business/company will include cash, accounts receivable, inventory, and basically any asset that can be liquidated or turned to cash in less than 12 months (so real estate and fixed assets will be outside the realm of Current Assets). The Current Liabilities of a business/company will include accounts payable, wages, taxes, and debt principal and interest.
The working capital is expressed as a ratio. If you had Current Assets of $100,000 and Current Liabilities of $50,000, then your working capital ratio is 2. This is optimal for most business owners and corporations.
If you had Current Assets of $50,000 and Current Liabilities of $100,000, then your Working Capital Ratio is 0.5, which is a very bad sign and a ‘negative’ ratio (below 1.0) Aim for a working capital ratio of 2.
The working capital ratio average tends to vary per industry. So you need to make sure that your working capital ratio is industry average if you are looking to sell or entice partners.
Net Working Capital is an absolute value. In the example above, the NWC is $50,000 provided you have Current Assets of $100,000 and Current Liabilities of $50,000. The ratio is usually more relevant and accurate.
Current Assets and Current Liabilities Breakdown
The following are some of the items that fall into the category of either Current Assets or Current Liabilities. You need to add all of them up to arrive at the complete figure. Then, you can proceed to divide the Current Assets by the Current Liabilities to get the Working Capital Ratio.
- Cash & cash equivalents
- Accounts Receivable and Accounts Payable
- Notes receivable maturing within one year
- Other receivables
- Inventory of raw materials, WIP, finished goods
- Office supplies
- Prepaid expenses
- Advance payments
- Accounts Payable
- Deferred Revenues
- Accrued Compensation
- Other accrued expenses
- Accrued Income Taxes
- Short Term notes
- Current Portion of Long term debt
Positive vs. Negative Working Capital
Working capital of 1 is even. It means that if your Current Assets and Current Liabilities are equal. Of course, this also means that you are not making any money! So try to have a working capital of 2, which is said to be a viable business. At least you are taking home some cash. With a working capital ratio of 1:1, you are likely losing money when all other factors are taken into account.
A working capital below 2 is viewed with skepticism by many investors. Take the example of Sears Holdings, which filed for Chapter 11 bankruptcy in October 2018. In 2005, the Working Capital Ratio of Sears Holdings was 3.62, quite an impressive ratio.
But by 2015, this ratio had plummeted all the way down to 0.96, a far more dangerous figure. The writing was on the wall, as such a low working capital ratio is a prime sign of business failure and imminent bankruptcy unless the situation is rectified. Things did not improve, and the company soon went bankrupt.
It is essential to maintain a working capital close to 2. A negative working capital (i.e below 1.0) is a sign of a failing business. It means that the business does not have enough funds to meet basic expenses and will have to borrow. Even if the business has a lot of fixed assets, these are not liquid enough to meet short-term operational expenses.
However, there are certain instances where negative working capital is ok, but this is mainly for larger corporations in some industries. An example might be McDonald’s, which has a huge inventory turnover rate and can generate capital quickly. With this model, the food is sold to customers and the chain will only have to pay suppliers later, despite the immediate turnover. Most companies cannot raise cash this quickly.
5 Tips to Improve Working Capital Ratio for a Small Business
#1 – Improve Sales
The most obvious and quickest way to improve your Working Capital Ratio is to increase sales. This will mean you have more profit and revenue. Of course, there are many ways to actually increase your sales and this is something you will be doing anyway.
But another factor is to collect on your accounts receivable on time. The accounts receivable is what you get paid, while the account payable is what you are paying out. Incentivize customers who pay early. The quicker you get the cash, the quicker your working capital ratio will improve. Make sure that all payments and invoices run smoothly and are promptly collected.
#2 – Streamline Inventory Management
Inventory management can get very complex, with a long list of suppliers, warehouses, distributors, vendors, etc. Make sure you are managing your inventory in the best possible manner. The stock needs to be gotten rid of as soon as possible and you don’t want to buy extra stock and then pay for storage fees. This will dig into your working capital.
The best way to do this is through a good inventory software management system. This will enable you to pinpoint which stock is selling very well and what stock is not selling at all. If you do have physical retail outlets, you must integrate your point of sale service with the inventory management software. It will make everything run a lot more smoothly.
#3 – Minimize Debt Service
For new businesses and startups, taking out debt is essential. You need to get up and running, and you can’t get started without the capital to see you through. But you could be taking out the wrong kind of loans with a higher origination cost. Debt servicing has an immediate impact on working capital. You will have to pay every week or month.
Some of the top lenders include OnDeck, Kabbage, PayPal LoanBuilder, SmartBiz, and Lending Club. The terms and conditions of these lenders are clear, so you know what you are getting into. Some of them, such as OnDeck, reduce rates for long-term borrowers with the platform. Either way, look into ways to reduce your debt obligation or to structure it in a way that better suits your business preferences.
#4 – Automate Accounts Receivable
Automating accounts receivable makes it a lot easier for customers to make payments. This increases customer satisfaction and ensures that payment is made more quickly. But a more important consideration is that this will vastly reduce costs.
Using an employee to manually take care of accounts receivable can be problematic if the employee leaves the business. There is still going to be some level of manual involvement in the accounts receivable process, but it needs to be automated as much as possible. A manual process can also result in mistakes, leading to a delay in getting paid.
#5 – Decrease Gap Between Accounts Receivable & Payable.
What can often happen is that there is a gap between accounts receivable and accounts payable. You might pay your accounts receivable every 30 days but only receive your accounts payable every 60 days. In other words, you pay every 30 days and get paid every 60. You are essentially financing your customers’ orders. You have to cover that 30-day gap in finance, possibly paying interest on this debt.
This won’t happen overnight. Try to entice customers to pay more regularly (around 30 days) and pay your suppliers every 60 days. This would make it a whole lot easier for you, though you’re going to have a tough time convincing suppliers. Good business is all about cash flow and liquidity, and paying them more infrequently increases the risk for them with no real benefits. You will have to offer them something to offset this.
Working Capital Formula Summary
Working Capital is a relatively straightforward (yet vital) metric to take into account. All businesses need to get the working capital ratio as high as possible, as it is a key sign for operational strength.
Take note of the tips above to increase your working capital ratio so you can grow and expand your business. If you are stuck for cash, consider a strong online lender.