Last editedAug 20222 min read
Working capital is one of the most fundamental management tools at a business’ disposal and it can signal either great prosperity or imminent decline for a company.
In this post, we’ll define working capital ratio, explain why it’s so important and what steps you can take to improve it and help your business thrive.
What is a working capital ratio?
Working capital ratio is the ratio of current assets to current liabilities. Current assets typically refers to assets which can be converted into cash within the year, for example inventory, accounts receivable, short-term investments and indeed, cash. Current liabilities, on the other hand, refers to any debt to be paid within the coming 12 months, as well as accrued liabilities such as tax.
Put simply, working capital ratio is the amount of cash your business has coming in proportional to how much is going out. The amount of cash you have left over after all current liabilities are subtracted from current assets is your working capital, and it reveals a lot about how efficiently your business is being run.
How to calculate the working capital ratio
The working capital ratio is calculated by dividing total current assets by total current liabilities. It can sometimes be referred to as the current ratio. It is an indicator of liquidity, in other words, a business’ capability to make due payments.
Generally speaking, the higher the ratio, the greater a business’ means to expand its operations. If the ratio is declining, however, it’s vital that you find out why and act to remedy it.
While the ideal ratio is industry and circumstance-dependent, a ratio of less than 1:1 usually indicates a serious issue.
The working capital ratio formula is shown below:
Working capital ratio = current assets/current liabilities
Simply calculating working capital, and not the ratio, is another simple equation. It involves taking the total of all current assets and subtracting the total of current liabilities. It can be expressed with the following formula:
Working capital = current assets - current liabilities
Why is working capital important?
Working capital is crucial as it reflects the overall health of a business. If a business doesn’t have enough working capital, it won’t be able to cover its operating costs, including paying salaries and suppliers. If this goes on, it can be fatal to a business.
On the other hand, a well-managed working capital reflects a healthy business. In fact, working capital is one of the main factors used to assess whether or not a company is a wise investment or not.
How to improve working capital ratio
If your working capital ratio is in the danger zone, there are a number of ways you can act to improve it. Some of these ways are outlined below:
Receive customer payments quicker
As accounts receivables are included in current assets, getting paid on time by clients is key to improving cash flow and working capital ratio.
GoCardless offers a number of solutions for helping businesses get paid on time. For recurring payments, GoCardless allows businesses to collect customer payments via Direct Debit. As payments are pull-based, businesses are in full control of the amount and frequency of payment, virtually eliminating late payments.
GoCardless customers can also take advantage of our Success+ solution which uses payment intelligence to manage and reduce payment failures. On average businesses can recoup 70% of failed payments. This can drastically improve cash flow and lead to big improvements in a business’s working capital ratio.
Manage inventory efficiently
Tightening inventory management can also help improve working capital ratio. Only ordering stock when it is needed avoids inventory surplus. Surplus should always be avoided as it essentially means you have working capital unnecessarily tied up in inventory.
Inventory management software can be very helpful in optimising stock orders and general management pertaining to inventory.
Increase creditor days
This basically involves increasing the amount of time you have to pay your suppliers. Naturally, this should be discussed with your suppliers beforehand.
Another key way to boost liquidity and improve working capital is to cut unnecessary expenses. To determine which expenses can be cut, you will need to carry out some analysis of operations and identify superfluous spending.
We can help
GoCardless is a global payments solution that helps you automate payment collection, cutting down on the amount of financial admin your team needs to deal with. Find out how GoCardless can help you with one-off or recurring payments.