Financing and Working Capital

Understanding working capital

Knowing your business’s working capital may help you gauge how well the company is operating.

Published: September 13, 2019

Working capital helps indicate the financial health of a business. It lets business owners quickly see the difference between what they owe and what they own. Tracking changes in working capital over time can show whether a business is heading toward distress or moving toward opportunities for growth. Lenders also look at working capital as a key indicator of whether to grant a loan to a business.

Refresher: Calculating your working capital ratio

Working capital, also known as net working capital, is the difference between your business’s current assets and current liabilities. Businesses use working capital to fund day-to-day operations and to invest in long-term growth. Anything that is either available or due within 12 months counts as current.

  • Current assets might include inventory, accounts receivable, and cash, along with investments and other property that can be quickly turned into cash.

  • Current liabilities might include accounts payable, short-term loans, taxes, and payroll.

Calculate the working capital ratio of your business with this equation: Current assets divided by current liabilities.

Analyzing your working capital ratio

Evaluating your working capital ratio can help you determine whether your business is using its capital appropriately and whether it has a reasonable level of debt.

Consider these general guidelines:

  • A working capital ratio above 1 likely means that your business is financially healthy.

  • A working capital ratio of 1.5 to 2 often indicates a business with strong liquidity.

  • A working capital ratio below 1 might signal your business does not have enough liquidity to effectively fund its operations.

Keep in mind: A higher working capital ratio isn’t always best. A working capital ratio above 2 may mean that your business is holding on to too much inventory — increasing the value of your current assets — or failing to invest in future growth. Though you might want to see a higher ratio if you are planning to rapidly expand your business.

It can be helpful to have a sense of the average working capital ratio of the businesses in your industry for comparisons.

Improving your working capital ratio

Working capital can fluctuate based on the seasonal trends of your business, so tracking this measure over time will give you a better sense of where you stand. Once you have an understanding of the working capital of your business, review these figures regularly to keep your company financially strong.

If your working capital ratio appears high based on your business needs, you may want to review your inventories and look for opportunities to invest excess cash.

If you’re concerned that your working capital ratio is too low, you may want to review the cash flow of your business. Could you make changes to your products or services, pricing, or target market to increase revenue? Can you improve your cash flow forecasting? Are you fulfilling orders and collecting accounts receivable efficiently? Perhaps you should aim to decrease the time it takes for customer purchases to be converted into cash.

You also might consider opening a business line of credit to use as working capital, especially if your business could benefit from a temporary increase in cash flow, such as during a period of expansion. Learn more about using a business line of credit as working capital.