The Working Capital Ratio – An Easy Explanation 

Here’s what the working capital ratio is, how to calculate it, whether it’s important to focus on for your business, and how to improve it when needed. 

The working capital ratio (also called the current ratio) shows a company’s ability to pay off its short-term debts from current assets and is used to measure whether a company can take on new debt while still being able to meet its near-term operating obligations. This is why suppliers, lenders, business owners, and financial institutions use the current ratio before making a decision. 

The working capital ratio is calculated using this formula: 

Working capital ratio = Current assets (CA) / Current liabilities (CL) 

A current ratio under 1 means a business won’t be able to pay off debts due within the next year and is at high risk of defaulting or going bankrupt, as the business has less cash or assets to sell for cash than bills it has to pay. Having a working capital ratio over 2 means the company could pay off all short-term debts twice over, as there are double the amount of cash or assets to sell for cash as bills due. 

Working capital ratios below 1 do not always mean trouble. High-volume budget retailers and fast food companies will collect cash immediately via point-of-sale equipment and cashiers, but pay vendors and suppliers on net 30-, 60-, and 90-day terms. This can result in a ratio below 1, but doesn’t mean trouble. Consulting companies may not stock inventory, and SaaS software companies use deferred revenue with pre-paid annual plans versus monthly billing and cash collection. This results in lower working capital ratios but isn’t necessarily a warning sign. 

All businesses have a working capital ratio, but industries structured around short-term operations where sales cycles move fast focus more heavily on their working capital ratio. 

Businesses that use the working capital ratio 

All businesses with inventory use the working capital ratio, but industries with short sales cycles and quick inventory turns will focus on it more closely because the business relies on short-term financing for operations. Industry suppliers and lenders will focus on the ratio when deciding to extend credit or to approve loans, as a way to make sure borrowers have the ability to meet their obligations. 

This is why certain types of businesses track their working capital ratio closely, as they’ll be evaluated when applying for financing. Examples of businesses that track their current ratio more closely include: 

• Retailers 

• Gas stations 

• e-Commerce stores 

• Seasonal businesses 

• Contract manufacturers 

As a business owner, keeping a close eye on your working capital ratio alerts you ahead of time if you will run into a problem paying bills. This lets you fix things before they become an emergency and you damage relationships. It also gives you time to improve your ratio before you apply for financing or supplier credit. 

Suppliers use the working capital ratio to evaluate your credit risk before offering trade credit terms like net 30/60/90. A high working capital ratio gives them confidence you’ll pay your invoices even if you haven’t sold through the inventory or materials they sold you on credit. 

Business lenders use the ratio to assess your default risk when approving small business loans, to make sure there’s enough buffer to cover existing debt plus the new loan. Check with your lender on their exact ratio requirements if yours is below 2, since different lenders will have different requirements. To calculate it, you’ll need to find your current assets and current liabilities. 

Where to find current assets and liabilities 

The working capital ratio has two main parts that you can find on your company’s balance sheet: 

• Current Assets 

• Current Liabilities 

Current assets are cash and other assets that you can convert into cash within one year, including: 

• Accounts receivable 

• Inventory 

• Stocks or bonds your business owns 

• Raw materials and Work in Progress (WIP) 

• Short-term loans (when the business is a lender) 

Current liabilities are the debts that you have to repay within the next year and can include: 

• Accounts payable 

• Deferred revenue 

• Deferred taxes 

• Accrued expenses 

• Gift card liabilities 

• Business credit card and business line of credit balances 

• Short-term business loans (when the business borrows money) 

Ways to improve your ratio 

The way to improve your working capital ratio is to either increase current assets or lower current liabilities. Here are some of the options you have available: 

• Refinancing short-term debt with long-term loans shifts liabilities from current to long-term, so your current assets stay flat, current liabilities decrease, and the ratio improves. 

• Selling long-term assets to increase cash shifts value from long-term assets to current assets while current liabilities stay flat, and your current ratio improves. 

• Using cash from long-term asset sales to pay off current liabilities keeps current assets flat because you generate cash from long-term asset sales, then immediately use that to decrease current liabilities for a better ratio. 

• Raising prices to increase cash or accounts receivable from sales works over time because the higher prices bring in more cash while you keep costs flat. This builds a cash buffer to increase current assets, or you could use it to pay down current liabilities — either way, it would improve your ratio. 

• Cutting expenses to build up cash in your bank account also works over time by conserving future cash to grow current assets while current liabilities remain constant. 

It’s also possible to improve your ratio by using short-term assets to pay off short-term liabilities. This works because of the ratio math: 

If you have $2M in current assets and $1M in current liabilities, your ratio is 2.0. By paying off a $500K short-term loan from cash, your new ratio becomes $1.5M / $500K = 3.0. 

A working capital ratio of 3.0 gives you plenty of breathing room in case sales slow down, or if you want to apply for a working capital loan to fuel faster growth. 

Your working capital or current ratio measures your ability to repay short-term obligations out of short-term assets. If your ratio is under 1, it means you won’t be able to pay your bills due over the next year and should take action now so you don’t default on one of your debts. If your ratio is over 2, then you have plenty of buffer as long as nothing changes. Anything between 1.5 and 2.0 is generally considered healthy, though this varies by industry — if your ratio is trending toward 1.2 or below, it’s worth watching closely to make sure it doesn’t move in the wrong direction. 

SmallBusinessLoans does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.