It’s an unfortunate fact of life that, generally speaking, you have to pay for stuff you need. And paying for that stuff – stock, raw materials, equipment, space, people to work for you – is part of owning a small business. Of course, you need to be able to generate enough money to meet those expenses. And to ensure you are in a position to do so, you need to understand your working capital.
Working capital is a way of measuring the short-term financial health of a business. Defined as the difference between current assets and current liabilities, your working capital position tells you whether you have sufficient cash on hand to pay off your short-term financial obligations.
Managing working capital well – ensuring assets exceed liabilities – is therefore crucial. More specifically, good working capital management involves close monitoring of inventories, accounts receivable, accounts payable, and cash flow.
Read our blog on the importance of maintaining steady cash flow: Better understand cash flow to ensure your business's financial health
Working capital management can be assessed using the following 3 ratios:
- Working capital ratio
- Collection ratio
- Inventory turnover ratio
1. The Working Capital Ratio
The working capital ratio, also known as the current ratio, gauges your ability to meet debt obligations, in other words, your business’s liquidity. It shows you the proportion of your assets relative to your liabilities, and is calculated by dividing current assets by current liabilities.
(Note: your ability to meet long-term debt obligations is determined by the solvency ratio – total assets divided by total liabilities.)
A working capital ratio of less than 1.0 – known as a working capital deficit – means your current liabilities are greater than your current assets, and that consequently you will struggle to meet your short-term debt obligations.
A working capital ratio of more than 1.0 means your current assets exceed current liabilities, and that you have enough cash flow to run your day-to-day operations.
Read our blog discussing, 8 Easy ways to secure your business cash flow
Analysts consider anything between 1.5 and 2 as the ideal ratio, while anything over 2 could imply a business has excess inventory or is not efficiently investing surplus cash.
2. The Collection Ratio
The collection ratio is defined as a company’s accounts receivable relative to its average daily sales. The collection ratio is the average amount of time (measured in days) that it takes your company to convert receivables into cash. It is also known as the “average collection period.”
To calculate average daily sales, you divide sales for an accounting period by the number of days in the accounting period (i.e. annual sales divided by 365, if you are calculating an accounting period of a year). That figure, divided into accounts receivable is the collection ratio.
By itself, the average collection period does not tell you much about the health of your business. What matters is context. How high is it relative to the credit terms extended to your customers? For example, an average collection period of 30 days isn't concerning if invoices are issued with 60-day payment terms.
The recommended ideal is to maintain an average collection period lower than one third greater than specified payment terms. For example, if a business asks its customers to pay for their credited items within 21 days, it can use an average collection period of 28 days as its threshold.
At the same time, standard collection ratios differ for different industries. You should always compare your collection ratio to other companies in your industry to gauge whether you are waiting too long to be paid.
3. The Inventory Turnover Ratio
The inventory turnover ratio is used to measure the liquidity of a company’s inventory. It is used to calculate the number of times a business has sold and replaced its inventory during a given accounting period. The frequency with which a company can sell inventory is a critical measure of business performance.
To calculate the inventory turnover ratio, use the following formula:
Cost of goods sold is equal to cost of goods manufactured (purchases would be used for a trading company) plus opening inventory less closing inventory. Average inventory is equal to opening balance of inventory plus closing balance of inventory divided by two.
The inventory turnover ratio indicates how efficiently a business is managing its inventories. A high inventory turnover ratio typically indicates efficient operations, with fast moving inventories, while a low inventory turnover ratio means poor inventory management, with slow moving inventories. Perhaps there is a slowdown in demand for your product or you are buying too much stock relative to demand.
It should also be noted that a very high inventory turnover ratio may be indicative of problems meeting customer demand due to poor inventory management. However, this would not apply where the stock in question is perishable goods which lend them themselves to a high turnover rate by necessity.
In other words, like collection ratios, ideal inventory turnover ratios can vary for different industries. You should always make sure to compare your inventory turnover ratio to other companies in your industry to determine the liquidity of your company’s inventory.
In Summary:
Efficient working capital management through ratio analysis is crucial to help ensure the financial health of your business.
For more on working capital management you can download our eBook "The basics of effective working capital management", which will help unlock hidden capital reserves and improve the operational performance and profitability of your business.
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