What is a Good Working Capital Ratio?

The basic principle of business health is fairly straightforward: you want more assets than liabilities. This is where working capital comes in, representing the lifeblood of a company’s short-term financial health and business liquidity. It can also show whether a company should take advantage of new opportunities or hang onto its money. Knowing how much working capital a business has on hand and how much it needs in a given period is one of the best ways to identify whether it can expand or needs to cut costs.

Working capital is the amount of money necessary to support short-term business operations. It can also be defined as the difference between current assets (such as cash and inventories) and current liabilities (such as a bank credit line or accounts payable). It’s one of the most important indicators of financial health because maintaining satisfactory working capital supports an organization’s day-to-day operations and is essential to its stability.

Now, what is the working capital ratio? It is a measure of business liquidity, calculated simply by dividing a business’s total current assets by its total current liabilities. In other words, it measures the health of the company’s short-term finances.

Working capital ratio formula

Working capital ratio = current assets/current liabilities

This ratio demonstrates operational efficiencies and indicates a company’s ability to manage its assets and liabilities. This allows a company to invest in growth opportunities or withstand financial hardship, which is top of mind given all the economic uncertainty.

What is a good working capital ratio?

A good working capital ratio is considered to be between 1.5 and 2, and suggests a company is on solid ground. Here’s a breakdown of how to interpret a working capital ratio:

  • Below 1: This suggests potential trouble meeting short-term obligations. The company might struggle to pay its bills on time.
  • 1.5 to 2: This is considered a healthy range, indicating a good balance between liquidity and efficient asset management.
  • Above 2: While this shows the company has strong liquidity, it could also mean they’re holding onto too much idle cash that could be better invested for growth.

Interpreting a negative working capital ratio

Negative working capital occurs when a company’s current liabilities exceed its current assets. In simpler terms, short-term debts (accounts payable, upcoming bills) are higher than readily available resources (cash, inventory, receivables). This scenario is often reflected in a current ratio less than 1. This can lead to worries regarding meeting payroll, paying debt, and may signal serious financial trouble. A negative working capital can be a sign of a decrease in revenue, mismanagement of inventory, or payments not being collected timely.

It’s important to note that there’s no one-size-fits-all answer for a perfect working capital ratio. Industry can play a big role, as some businesses, particularly those with very short operating cycles (like retailers), naturally have negative working capital. They sell inventory quickly and collect payments fast, keeping current liabilities high but minimizing the need for holding cash. Additionally, rapidly growing companies might prioritize investment in inventory or expansion over immediate profitability, leading to negative working capital in the short term.

We note a cause for concern can arise when negative working capital is chronic, which can cause cash flow issues.

How to improve working capital?

Figuring out a good working capital ratio and then keeping an eye on cash flow can help businesses understand when a shortfall lies ahead. This can help them take the necessary steps to maintain liquidity. There are several ways to boost working capital to ensure you avoid a negative working capital ratio. 

Allianz Trade lists the below techniques:

  1. Shorten Operating Cycles
    1. Options to shorten your operating cycle and generate working capital faster can include asking for deposits or upfront payment, reducing credit terms, and billing as soon as a sale is made. You can also take a harder look at sales forecasting and demand planning, as well.
  2. Avoid Financing Fixed Assets with Working Capital
    1. Every business owns or intends to own fixed assets such as buildings, equipment, vehicles or land. These assets are used to generate long-term growth. While selling a fixed asset can boost cash flow and working capital, financing a fixed asset with working capital is never a good idea. Fixed assets tend to be expensive and paying for them not only depletes working capital but increases the risk profile that financial institutions use to determine creditworthiness. A better strategy is to use long-term loans or a lease to finance fixed assets.
  3. Perform Credit Checks on New Customers
    1. Before you take on a new client or extend credit, do some research into the prospect’s creditworthiness. This due diligence will help you improve your trade working capital by indicating if a new client is likely to default on payment or pay you on time. 
  4. Utilize Trade Credit Insurance
    1. Trade credit insurance acts as a safety net to protect your business from non-payment of your accounts receivable. This frees you from maintaining bad debt reserves and helps you protect your capital, maintain your cash flow and secure your earnings while extending competitive credit terms to your customers. Banks consider receivables insured by trade credit insurance as secured collateral. This often means they will lend more money at a lower interest rate to companies that have trade credit insurance.
  5. Cut Unnecessary Expenses
    1. Another way to increase liquidity to support working capital is to cut expenses. Careful analysis of variable business expenses can often uncover savings opportunities through expense reduction or cost cutting.
  6. Reduce Bad Debt
    1. Bad debt, or uncollectible receivables, can happen in any business that extends trade credit. As bad debt increases, working capital decreases. Options to reduce bad debt and free up working capital can include selling more higher-margin products or increasing margins across your offerings. Tightening up credit management processes and collecting payments faster is also effective. To combat bad debt, you can reduce inventory by recalibrating stock levels and using just-in-time logistics.
  7. Find Additional Bank Finance
    1. A relationship with your financial institution can also be a good hedge against bad debt and a great way to increase working capital. To access financing and receive lower interest rates on loans to support working capital, you must have regular communication with your bank. Share how your business finances are structured, how you generate revenue and what actions you take to protect your margins. This open communication can provide leverage when your financial institution does their risk assessment and due diligence prior to lending you money.