The Working Capital Ratio—Explained

The working capital ratio is a number that every business owner should know. Working capital ratios compare a business’s current assets to its liabilities. The ratio is important to figure out the liquidity of said business. This is important because liquid businesses can get cash on hand quickly if they need it.

When assets exceed liabilities, then a business has the capital to cover day-to-day operations. This means the business can function on its own.  Sounds simple? Maybe, but it’s also important to keep track of. You may want to find your ratio to see if you have enough capital to cover a purchase. Banks may want to know this number if your business is being evaluated for a loan.

Breaking Down The Numbers

Finding the working capital ratio for your business is easy. Simply divide your total current assets by your current liabilities. The number you get is your ratio. Assets include inventory, short-term investments, as well as cash. Liabilities include salaries, short-term debt, and taxes.

For example, a business with $3,000,000 in assets and $1,500,000 in liabilities would have a working capital ratio of 2.

The magic number in terms of ratios is 1. Any number above 1, means that the business in question can pay off its expenses with its assets. At 1, you’re breaking even, so the higher the better. Higher numbers mean you have more assets. With a ratio of 2, our business is doing quite well! This state is what is called positive working capital.

A working capital ratio lower than 1 is a problem, though. This is called negative working capital. It means that a business can’t cover its expenses with the current assets it has. If a business has a working capital ratio lower than 1 for a long time, it probably isn’t being run well.

Also, a company may get caught up in its success and grow too fast. As a result, it takes on a lot of expenses at once. Even if it’s making money, the asset growth doesn’t match. This leads to a low working capital ratio, and a potential nasty surprise for the business owner.

How Do You Fix A Poor Working Capital Ratio?

If you have a low working capital ratio, creditors and investors will be the first to notice. In their eyes, this is a huge red flag. Since your business can’t cover its expenses, they may think it’s having trouble. This could lead to banks denying you loans. Investors may also be slower to jump on board. If they think things aren’t organized, it could hurt your loan chances.

Working capital ratios aren’t perfect. Sometimes, they don’t tell the entire story. Companies that have the majority of their assets in inventory may have lower ratios but not be hurting. This is because those assets turn into cash slower than others. Businesses that are drawing down cash from a line of credit may have a similar issue. The reason here is that they don’t keep much cash on hand. This is rare, though. Low working capital ratios mean your business isn’t healthy in the eyes of many.

Using Merchant Cash Advances To Help

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Article Name
Understanding The Working Capital Ratio
The working capital ratio may sound obscure, but it could determine the health of your business. Learn what it is and how to use it.

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