What Is a Good Working Capital Ratio?

In business finance, the working capital ratio indicates a company’s short-term financial health and efficiency. Maintaining a good working capital ratio is essential for measuring liquidity, managing debts and fostering growth for your small businesses.

Let’s break down what a good working capital ratio looks like, how to calculate it and why it matters for your small business.

What Is a Good Working Capital Ratio?

Think of the working capital ratio, sometimes called the current ratio, as a snapshot of your business’s financial health. It compares your company’s current assets (like cash on hand, accounts receivable and inventory) to your short-term liabilities (like loans and accounts payable).

A ratio between 1.5 and 2 is generally seen as just right — it means you’ve got a healthy balance. You’re able to pay off debts while still having enough to grow. A high working capital ratio can be a mixed bag, suggesting you might be sitting on too much inventory or not investing enough in growth.

How Do You Calculate Your Working Capital Ratio?

To calculate your working capital ratio, divide your current assets by your current liabilities. Both of these figures are found on your balance sheet. This calculation tells you if you have a positive working capital or negative working capital.

Here’s what the working capital ratio formula looks like:

Working capital ratio = current assets/current liabilities

What Is the Difference Between Working Capital and the Working Capital Ratio?

Working capital is the money a company has available to pay for its daily activities after covering its short-term debts. It’s calculated by subtracting current assets from current liabilities.

The working capital ratio, on the other hand, assesses a company’s liquidity and ability to meet short-term obligations. It’s calculated by dividing current assets by current liabilities.

While working capital uses a dollar amount to illustrate available resources, the working capital ratio illustrates them proportionally. This further helps business owners understand if their company has enough current assets to cover its current liabilities.

How Does Working Capital Impact Your Business?

Working capital is the engine of your business operations. It affects everything from paying your suppliers and employees on time to seizing new opportunities. Good working capital management ensures you have a smooth operating cycle, improves cash flow management, and maintains a solid liquidity ratio all of which are crucial for both day-to-day survival and long-term profitability.

What Happens if You Have a Negative Working Capital Ratio?

Having negative working capital means your short-term liabilities outnumber your short-term assets. This situation can lead to liquidity problems, making it hard to cover your financial obligations. It’s a warning sign that your business might need to adjust its cash conversion cycle or rethink its inventory management strategies.

How Do You Improve Your Working Capital Ratio?

Achieving a higher working capital ratio is all about balancing the amount of money coming in and going out. Here are a few strategies:

• Get invoices paid quicker to boost your accounts receivable.
• Keep an eye on inventory levels to avoid excess without running out of what you need.
• Negotiate better payment terms with suppliers to keep more cash on hand.
• Consider refinancing short-term debt to ease the pressure on your current liabilities.
• Explore a line of credit for more breathing room.

The Bottom Line

A number in the 1.5 to 2 range is typically a good working capital ratio. You want to have enough cash flow to cover your bills, invest in new opportunities and build a buffer for those unpredictable moments.

The working capital ratio reflects your business’s ability to meet short-term obligations and fund its growth. By understanding and managing this key metric, you’re paving the way for your business to thrive.