What is a Working Capital Ratio?
A simple KPI tells your business health.
There’s a variety of numbers to choose from when assessing the health of your business but the Working Capital Ratio is one that’s commonly used. It is relatively simple to prepare (even without a tool like Calxa!) and it provides a quick guide to your short-term ability to pay your debts.
How is it calculated?
It’s your Current Assets divided by your Current Liabilities. Now, if you haven’t studied accounting, you may still be none the wiser so let’s convert that to plainer English.
Current Assets are the things you own (technically it’s things you have rights to but let’s keep it simple), that can be converted to cash fairly quickly. Bank accounts are an obvious inclusion but also in there are things like your outstanding debtors (the customers who owe you money) and your inventory or stock on hand.
On the other side, Current Liabilities are the things you owe that need to be paid in the short term (and that’s generally a 12-month timeframe). This includes things like credit cards, loans, accounts payable, what you owe for GST and payroll.
Good, Bad or Ugly?
Now, you have identified your Current Assets and your Current Liabilities and divided one by the other and you get a number – some people prefer to use a simple number, others to express it as a percentage. How do you know if you should be worried or if you can relax?
If the ratio is less than 1 or 100%, that’s generally seen as a warning sign. You don’t have enough Current Assets to pay your Current Liabilities. You owe more than you own or are owed. A working capital ratio of 80% suggests that for every dollar you owe, you only have 80c available. That’s bad. It doesn’t mean you should panic but it may be time to watch your cashflow carefully and to get advice about a longer-term plan for prosperity.
A ratio of around 2 or 200% is usually considered a healthy sign of short-term liquidity. You shouldn’t have trouble paying your creditors, keeping your credit cards under control or keeping the taxman happy. That’s good.
Factors for Consideration
Be wary of a couple of factors that can inflate your working capital ratio though: the first is long-term bad or slow-paying debts – if your accounts receivable balance includes amounts that are unlikely to be paid or won’t be paid for a long time, the ratio is overstated.
Similarly, if you have very slow-moving inventory, it’s questionable whether that should really be considered a current asset (in Calxa you can easily edit the KPI account group to exclude it if necessary).
Monitoring the Trends
As with most KPIs, it’s monitoring the trends rather than the one-off values that really gives you insights into your business. A business with cash sales can operate for quite some time with a very low working capital ratio, while that’s more difficult for others.
The key thing to watch is whether yours is getting bigger (start to relax a little!) or declining. If you started the year with a ratio of 200% but it’s gradually dropped to 120% by April, you should be looking at why. Have you used cash or credits to buy assets that would have been better with long-term finance? Are sales declining? Are your margins being squeezed?
The ‘I’ in KPI
Remember that ‘I’ stands for Indicator. It’s a sign that things are going OK or not so OK. On its own it doesn’t tell the whole picture but it gives you a good glimpse, very quickly, and that’s why it’s useful. Monitor the trends and use it for an early warning sign of trouble to come.
If you want to have a go at KPIs have a look at some of the default KPIs available in Calxa.
Tags: AccountantNFPSmall Business