What is Working Capital Ratio and How to Calculate It

Introduction

Businesses don’t struggle because they have less cash reserves. They struggle because of inefficient working capital management, which often leads to non-payment of financial obligations. Moreover, without this holistic view of financial resources, businesses end up losing significant opportunities, resulting in lower returns. 

This is where the working capital ratio comes into play. As a crucial liquidity metric, it helps businesses determine if they have enough assets to settle short-term financial obligations while having enough reserves to meet their daily needs. 

This blog dives deeper into the working capital ratio, its definition, type and calculation method, its interpretation and improvement strategies. 

What Is A Working Capital Ratio?

The working capital ratio or the current ratio helps businesses measure their liquidity by dividing current assets by current liabilities. This ratio helps estimate a business’s current assets as a proportion of its current liabilities and assess its operational efficiency and financial health.

The working capital ratio is calculated by dividing total current assets by total current liabilities. The ratio indicates how capable a business is of paying off its short-term liabilities using its current assets while managing its day-to-day operations efficiently. 

Why does the working capital ratio matter?

The working capital ratio is used by businesses and stakeholders to determine the availability of current assets to settle short-term debts. It’s an important tool to identify and streamline a company’s ability to manage its short-term liabilities while optimizing its working capital for efficient business operations. For businesses, the working capital ratio matters because it acts as a benchmark for their financial performance and helps predict and prevent cash flow issues in the long run. 

• Liquidity assessment 

  The working capital ratio provides insights into a business’s liquidity management and its ability to meet its short-term obligations. A higher ratio represents better liquidity, while a lower ratio indicates financial bottlenecks.

• Creditworthiness and investor confidence

  Lenders and creditors often rely on the working capital ratio to evaluate a business’s creditworthiness. A business has a good chance of obtaining financing on favorable terms if it has sufficient current assets to cover short-term liabilities.

  Moreover, a strong ratio shows financial sustainability and stability, instilling investors’ confidence.

• Operational efficiency

  A well-managed working capital ratio reflects efficient management of inventory, accounts receivables, and payables. It means a business can effectively manage its cash flow and working capital cycle while optimizing operational efficiency. 

• Risk management

  Calculating the working capital ratio and monitoring changes over time can help businesses identify potential financial risks and vulnerabilities. A declining ratio signals that a business has less liquidity or is increasing its financial obligations, calling for proactive risk management to address these challenges. 

Protip: When speaking of current ratio vs. working capital ratio, both are the same thing and used interchangeably. The current ratio, or working capital ratio, helps measure a company’s debt payment abilities using the available current assets. 

Working Capital Ratio Formula

The working capital ratio is calculated by dividing current assets by current liabilities. Current assets include cash, inventory, accounts receivable, prepaid expenses, short-term investments. Current liabilities include short-term debts, accounts payable, outstanding expenses, bank overdrafts.

Businesses can determine the amounts of current assets and current liabilities from the balance sheet. The working capital ratio is directly proportional to current assets and inversely related to current liabilities, serving as a fundamental measure of a business’s financial solvency. 

Steps To Calculate Working Capital Ratio

Calculating the working capital ratio is a straightforward process. Here are the steps to calculate the ratio:

What Is A Good Working Capital Ratio? 

A good working capital ratio typically falls between 1 and 2, suggesting a business has a robust liquidity position and efficient collection management. A good working capital ratio ensures prompt payment from customers and that it has enough cash reserves and pays debts on time without any difficulties. 

Types of working capital ratio and how to interpret them

A working capital ratio can be a high or positive ratio ( ratio of equal to or higher than one)Or low or negative (ratio of less than one). 

•  High working capital ratio 

  A high or a positive working capital ratio signifies a ratio of more than one. It shows that a business has a strong financial position, robust liquidity and solvency status and that it has adequate current assets to settle short-term liability. However, a very high working capital ratio is not always good sign and can harm business performance in the long It means a company is unable to make an effective use of the high current assets, that might further lead to unfavorable returns on asset (ROA) ratio, a crucial profitability metric used by investors and stakeholders to assess financial performance.

  Interpreting a higher working capital ratio

  A working capital ratio between 1.5 and 2.12 is usually considered ideal, as it shows financial soundness and healthy liquidity. However, an excessively high working capital ratio is not good, as it signals that a business has a huge idle cash surplus, which could have been reinvested effectively for better returns. 

• Low working capital ratio 

  A ratio below one indicates a lower or negative working capital ratio. This means that a business has a negative cash flow with current liabilities exceeding its current assets. This can result from reduced sales revenue, a lack of inventory management, or account receivables issues, indicating that the business may have trouble repaying its lenders.

  Interpreting a lower working capital ratio

  A working capital ratio below one means a business has a negative cash flow with poor asset management and is unable to cover its financial obligations with the available working capital. In such a situation, a business will most likely face difficulties in paying back its lenders and suppliers, along with other financial challenges. This might also lead to situations where a business has to seek additional finance to fund the operation and even face insolvency if the circumstances persist. 

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  A lower working capital ratio is not always a bad sign

  Despite being trusted by finance teams, analysts, stakeholders, and investors, the working capital ratio does not give a comprehensive overview of a business’s liquidity position. It only shows the net result of the total liquid assets available to settle short-term liabilities in the near term. It also fails to outline any additional financing that may be available, like unutilized credit lines. 

Additionally, businesses often avoid using credit lines to minimize excess interest costs. This cautious approach might make the working capital ratio unusually low. However, it is still a critical liquidity metric r, as it helps detect and navigate critical issues like delayed payments from customers, which, if unresolved, could trigger long-term cash flow problems. 

How To Improve Working Capital Ratio?

Optimizing the working capital ratio is crucial for ensuring effective working capital management, maintaining a healthy financial position, and achieving operational excellence. A perfect balance between current assets and liabilities helps businesses unlock sustainable growth while maintaining a strong liquidity position. Here are a few ways that can help companies improve their working capital ratio.

• Streamline cash flows

  Businesses must prioritize reducing their liabilities, increasing their cash reserves and streamlining cash flows to maintain healthy cash positions. This can involve utilizing techniques such as improving inventory management to free up any tied-up capital, boosting collections against accounts receivable, etc. 

  An automated cash management system helps businesses gain complete visibility over cash reserves across banks and regions, effectively handle transactions, ensure timely payments, detect unmatched transactions and reconcile them, and more. 

  

• Rethink debt payment terms 

  Businesses can negotiate favorable debt payment terms that help them align their cash flow needs and prevent utilizing working capital to settle liabilities. Negotiating longer payment terms and leveraging early payment benefits with lenders and suppliers not only helps reduce the overall borrowing costs but also keep current liabilities under control. This enables them to avoid late payment penalties like shortfall interest charges. 

  Tools like debt/investment management systems can help businesses deal with the debt lifecycle and streamline debt with integrated cash flow tracking. This enables them to create, track, and manage debts in a centralized location such that businesses gain a comprehensive overview of their current liabilities and avoid late or non-payment. 

• Leverage short-term financing 

  Businesses can also go for short-term financing options, like a line of credit, to ensure a buffer period during cash flow crunches and fund their growth initiatives. These options provide the required liquidity to manage operational fluctuations. 

  Cash forecasting tools can help businesses understand their cash flow status in the near future, enabling them to make smarter investment and borrowing decisions. By determining their daily working capital needs, businesses can prioritize reserves and borrow additional funds if required. 

  

• Effective inventory management 

  Inventory is one of the major reasons behind working capital ratio fluctuations. Excessive inventory means a business is unable to turn its inventory into revenue, and tying up substantial working capital. On the other hand low inventory levels poses challenges in meeting customer demands. 

  To maintain a balanced inventory, businesses should regularly review inventory levels and remove obsolete stock that is tying up working capital. They can also implement inventory turnover strategies like discounts for slow-moving products, aligning inventory with sales trends, and can enhance liquidity. 

• Improve the cash conversion cycle

  The cash conversion cycle (CCC) helps businesses determine how long it will take to convert their investments in inventory and other assets into cash generated from sales. By reducing the CCC, businesses can accelerate cash inflows, which in turn will increase their working capital. Businesses can either shorten the time it takes to collect payments from customers or optimize their production and delivery processes.

• Accelerate revenue collection

  One of the major ways to boost the working capital ratio is to increase cash inflows through revenue collections against invoices. Businesses can reduce the collection period to ensure swift conversion of invoices into cash flows. They can also establish and apply clear credit policies and follow up on overdue accounts to accelerate revenue collections. 

  Solutions like electronic invoicing software can help businesses streamline customer invoices and ensure swift revenue collections. Moreover, they can also leverage smart email invoices to send payment reminders to customers at intervals, track late payments, and manage disputes for buyers. Additionally, leveraging advanced AI for AR forecasting will help businesses project payments from customers and invoices and forecast cash payments. 

Boost Your Working Capital Ratio With HighRadius’ Treasury and Risk Suite

To maintain a good working capital ratio and ensure an accurate balance between current assets and current liabilities, businesses need solutions that help them streamline processes for debt payments, collections from customers, cash positioning, etc. With this in mind, HighRadius offers cutting-edge, advanced tech right from its Treasury and Risk Suite – automated cash management and cash forecasting solutions. 

Our Cash Forecasting solution leverages advanced AI and ML and integrates with banks and ERPs to get AR/AP data. These are customer specific AI models built to improve upon the Auto-ML accuracy rate for AR and AP category and leverages information like customer and vendor invoices, purchase and sales orders, credit and debit memos, etc. 

Similarly, our Cash Management solution automates the reconciliation process between bank statements and internal financial records, and streamlines cash transactions. Businesses can seamlessly manage debt lifecycles and track and deal with settlement instructions to ensure timely payments. Additionally, they can create unlimited cash position templates to analyze global cash visibility and identify the bank accounts with low balances and fund them. The cherry on top – our out of the box integration with all major banks provides businesses with rapid access to bank statements and help categorize cash into inflows and outflows

FAQs

1) What is the revenue to working capital ratio?

A revenue to working capital ratio is a liquidity metric that identifies a business’s ability to generate revenues from its working capital and is often used interchangeably with the working capital turnover ratio. It is calculated by dividing annual sales by the average working capital. 

2) Current ratio vs. working capital 

The current ratio is represented by a number and determines a business’s current assets in excess of its current liabilities. The working capital, on the other hand, is an absolute dollar amount and determines the cash and other liquid assets a business has to cover its short-term debts. 

3) What does the working capital ratio tell you?

The working capital ratio helps determine a business’s current financial obligations and indicates how much of its revenue can be used to meet its short-term debts. A ratio between 1.5 and 2 is considered ideal as it shows a business’s ability to meet its obligations with existing current assets.

4) Can the working capital turnover ratio be negative?

The working capital turnover ratio is calculated by dividing sales revenue by working capital (that is, current assets minus current liabilities). While sales revenues cannot be negative, if the working capital is negative, the working turnover ratio can become negative. 

5) How to calculate the net working capital to sales ratio?

The net working capital to sales ratio, or working capital turnover ratio, is calculated by dividing sales revenue by working capital, which is derived from subtracting current liabilities from current assets. It shows how well a company can generate sales from its working capital.