Running a business can be easy if you have more control of your finances and critical activities like inventory management. Once you master inventory management, quantify your assets and determine your liabilities. These two components are critical to managing your company since they indicate the nature of your performance and business success.
Understanding your current assets and liabilities allows you to calculate your working capital ratio (WCR). This is the greatest tool for every business owner to manage key financial decisions.
To stay ahead of business operations and strategy, you should know how to calculate Working Capital Ratio and interpret the ratios for your business. This article helps you answer these questions to manage your business better.
1. Understanding Working Capital Ratio
Before understanding the ratio, you need to know what working capital (WC) is and how it matters to your business operations. In short, it is the business’s short-term financial health and capabilities. For smaller businesses, the capital in your current assets can easily be used to finance daily and critical business operations.
It measures your ability to meet your obligatory business expenses without needing much capital by liquidating assets. To understand the amount you have in your working capital portfolio, you need to determine your assets and liabilities.
Therefore, WC is the difference between current assets and current liabilities. The amount can be used to finance daily business operations. Now that you know the working capital, you can now explore the working capital ratio.
First, you need to know how to calculate the ratio. You already know the current assets, which you can easily convert to liquidity, like cash, inventory, and other receivables. Next is the current liability, the short-term business debt you must pay within the year. Such liabilities include short-term loans and accounts payable.
Therefore, here is how to calculate the working capital ratio:
The formula is Current assets / Current liabilities. The answer you get can be expressed in decimals or percentages for better understanding. After calculating the ratio, you should understand what it means.
2. Interpreting WCR
If the ratio is above 1, including 1.001, it indicates that your business has enough current assets, which are ideal for your current obligations. It also shows the ease of converting into liquidity, which you can use for finance daily operations.
Secondly, if the ratio is below 1, like 0.9999, it should be considered a red flag. This means that your business may have severe challenges meeting current liabilities. You may struggle to meet all these expenses and finance your daily operations.
3. What Does WCR Indicate
You should be alert if your ratios are high, especially two and above. This ratio should not be excessively high, indicating you have too many assets. A good business strategy is to balance the current assets and liabilities. This balance is crucial for managing the asset-to-liability ratios, which is critical for business functionality.
When the working capital ratio is too high, beginning with 1.7, it shows that you may have too much inventory, which can affect your liquidity and working capital. This can tie up your capital, affecting the cash you need to meet fast obligations.
Secondly, a very low ratio is a significant red flag and a major risk for your business. First, it shows that you will likely go bankrupt since you have more debt. It can be the perfect call to turn things around to help you avoid the red zones likely to affect your business reliability.
4. The Benefits OF Working Capital Ratio
You should calculate the ratio quarterly to have a deeper glimpse into how the business operates.
Managing Your Business Inventory
It is an indicator of how much inventory you have in your business. A too-high Working Capital Ratio ndicates that you are holding too much inventory. This can lead to higher asset management expenses; hence, you need to eliminate some assets to increase company cash assets.
Having touch assets can also lead to other complications. For instance, it affects your ability to pay your vendors. Further, it indicates that you may be having cash asset issues due to holding up too much capital in assets.
Finally, you can use the ratio to determine the company’s financial health, which includes debt management, payroll expenses, meeting utility obligations, and other commitments that require daily payments.
Ability To Invest
The Working Capital Ratiocan also determine your ability to pay for your major investments. High ratios show high assets, which can affect your ability to grow your business. Too many assets indicate two things: too many assets due to uncontrolled expansion, which affects your capital. Next, it shows that you may not have enough cash to expand your operations, like entering new markets.
Most businesses expand by relying on liabilities, mainly debt. Due to low ratios, you may have issues growing your business if you have too much debt. This is because you spend all your cash servicing debt repayments rather than investing.
Finally, the ratios may indicate your ability to boost capital by leveraging assets. For example, higher assets than liabilities indicate that you can get more debt using asset volumes as collateral. You can then use this capital to finance your expansion agenda. Ensure you have high-return assets, which can easily increase your cash revenues, boosting your liquidity and ability to meet debt obligations.
Significant Warning Signs
You should calculate the ratios frequently to understand what is going on in your business. They are the warning signs for bankruptcy and financial challenges. On the positive side, they show your ability to meet the obligations.
Conclusion
Even if you do not have a company accountant, you must frequently do a book analysis of your assets and liabilities. Based on your values, you need to calculate the Working Capital Ratio quarterly to get a glimpse of your business operations. Based on the ratios, you can begin planning your operation to take advantage of the situation or address the red signs.
