What Business Owners Must Know About Working Capital and Liquidity Ratios
November 12, 2024 | Last Updated on: November 12, 2024
Disclaimer: Information in the revenue-based financing articles is provided for general information only, does not constitute financial advice, and does not necessarily describe Biz2Credit commercial financing products. In fact, information in the revenue-based financing articles often covers financial products that Biz2Credit does not currently offer.
In this article, you’ll learn:
- What working capital is
- What liquidity ratios are
- Why strong working capital and liquidity management are important for your small business
- How to improve your working capital and liquidity ratios
“Cash is king” is a common saying in the business community for good reason – it can be a game-changer during a crisis. Your company’s liquidity will determine how well your business can meet its short-term debt obligations without taking out a working capital loan or raising outside capital. It’s essential to continually have sufficient cash and other liquid assets on your balance sheet to meet current liabilities to ensure your business’s long-term success.
Calculating certain financial metrics, such as your company’s working capital and a few liquidity ratios, can give you valuable insights into your small business’s ability to navigate short-term setbacks.
What is Working Capital?
A basic working capital formula is your total current assets minus your current liabilities. Your assets include cash and cash equivalents, accounts receivables, and inventory that can be sold or used in your business operations within 12 months. Your current liabilities are calculated by adding up the amounts you need to pay creditors within 12 months. Examples are accounts payable, accrued expenses, notes payable, and taxes payable.
Sufficient working capital will ensure the operational efficiency of your business. At the bare minimum, you want your current assets to exceed your current liabilities. If you have negative working capital, or your current liabilities are greater than your current assets, you’re likely to run into cash flow problems over the next year. It’s essential to prioritize working capital management to maintain your business’s day-to-day operations.
So, how do you know if you have enough working capital?
It depends on your company's size and industry. For some companies, $10,000 in net working capital is enough. But for others – perhaps bigger companies with unpredictable quarterly financial performance – $10,000 in net working capital is too little.
Working capital ratio (current assets/current liabilities) is a better measurement of your company’s financial health. In most cases, a ratio between 1.5 and 2 means that your company is in good shape. Your working capital ratio, also known as your current ratio, is a type of liquidity ratio.
What are Liquidity Ratios?
Liquidity ratios assess a company’s ability to pay off its short-term debt obligations without raising external capital. It might seem like knowing your net working capital and working capital ratio is sufficient.
Well consider this: what if all of your short-term liabilities are due in three months? But your company’s current assets won’t be turned into cash for at least six months. In this case, your company’s working capital ratio could be 2 or 3. While that’s usually a healthy ratio, you could still be in a bind.
We’ve already introduced the current ratio, but here are a few more common liquidity ratios to more comprehensively assess your company’s short-term financial health.
Quick Ratio
The quick ratio is also known as the Acid Test Ratio. A good formula to determine this ratio is cash and cash equivalents + marketable securities + accounts receivable/current liabilities. This ratio doesn’t factor in inventory and prepaid expenses.
Days Sales Outstanding
Your days sales outstanding (DSO) is your average accounts receivable/revenue per day. A high DSO means that your company is taking too long to collect receivables, which could impact your ability to meet short-term financial obligations.
Operating Cash Flow Ratio
In running a business, cash flow management is essential to ensure that cash flows in at the right times and is available to meet operational expenses. The operating cash flow ratio is determined by dividing your business’s operating cash by its current liabilities. This ratio measures how often a company can pay its current debts with the cash generated by its business operations over the same period of time.
Consider All Four Liquidity Ratios
To determine your company’s ability to meet short-term debt obligations, it’s important to look at all four liquidity ratios. As stated earlier, a high working capital ratio can be deceiving. But if the other financial ratios are in healthy ranges, your company will likely have no problem meeting its obligations.
If one of the ratios is lower, it doesn’t necessarily mean trouble for your business. Say you have a quick ratio of .75, which is typically not great. If your operating cash flow ratio is 2.5, you might be in a strong overall position.
Why Strong Working Capital and Liquidity Ratios are Important for Your Small Business
While working capital and liquidity ratios are indicators of your small business’s ability to pay off its short-term debt obligations, they are lagging indicators. Since the future is impossible to predict, it’s best not to cut it too close with your numbers.
Here are a few possible scenarios that show the importance of having extra cash, but not too much cash, on hand:
Your Operating Cash Flow is Lower Than Expected
The past four years are a perfect example of something completely unexpected happening that can change your company’s fortunes. Imagine you had a restaurant in January 2020 with an operating cash flow ratio of 2.5 and a working capital ratio on the lower end. You’d probably feel optimistic about meeting financial obligations over the next 12 months.
But then COVID-19 destroyed the global economy. While COVID-19 may have been a once-in-a-lifetime pandemic, you only have to look back to the late 2000s to see the catastrophic effects of the Global Financial Crisis on countless companies.
You Struggle to Sell Current Inventory
Your inventory can have a significant impact on your working capital and liquidity ratios. If you have a hard time selling current inventory, you might have difficulty meeting short-term financial obligations if you don’t have enough cash on hand. Therefore, careful inventory management is crucial for the financial stability of your business.
The predictability of your inventory turnover depends on your industry. A small business that sells groceries has high predictability, while a small boutique company that sells expensive accessories has lower predictability.
You Want to Grow Market Share
Say you have a business with a 1% market share in an industry growing at a compound annual growth rate (CAGR) of 20% per year. You believe you can grow your market share to 10% over the next three years. To reach that potential, you may need to hire more staff and make capital expenditures. Both require up-front investments.
How to Improve Your Working Capital and Liquidity Ratios
By now, you likely understand the importance of positive working capital and strong liquidity ratios. But what do you do if your ratios are on the lower end?
You have several options to boost your numbers.
Take on Less Debt
This is easier said than done. But you might not really need everything you buy for your small business. By carefully considering the return on investment (ROI) of each purchase, you ensure that you’re only buying what you need.
Refinance Debt
There’s a way to quickly reduce your short-term liabilities and improve your working capital and liquidity ratios — Ask for longer payment terms on your short-term obligations. While this might be the right option for your small business, ensure you’re not paying a much higher interest rate on the new loan.
Boost Net Income
Boosting your net income is easier said than done. The obvious ways to increase net income are to reduce costs and increase sales or raise prices. Reducing costs in our current inflationary environment is challenging. Most businesses are left with raising prices. A higher net profit margin increases your cash position over time, which improves your working capital and liquidity ratios.
Use a Merchant Cash Advance
A merchant cash advance (MCA) provides a small business owner with a lump sum amount in exchange for a percentage of future sales. Often, the lump sum amount plus loan fees are due within a year. So, this financing option is typically suitable for a small business owner whose business needs more cash over the next few months but expects to be in a much stronger financial position within the next year.
Here’s what’s good about MCAs: you may be able to qualify with a lower credit score. The problem with MCAs, however, is the fees are usually high. You could end up paying a triple-digit APR when it’s all said and done – this is more likely if your sales are higher than expected, as the MCA gets paid back faster.
An MCA loan could work out very well for an entrepreneur with a good business idea. Say you want to run a $10,000 marketing campaign you believe will lead to at least $50,000 in sales. In this case, an MCA might be a smart choice.
Get a Term Loan
Like a merchant cash advance, a term loan provides upfront cash. But that’s where the similarities end. There are strict requirements, however. Many lenders ask for $250k in annual revenue, a credit score of 660, and 18 months in business.
A term loan is a good option for small business owners with long-term working capital needs. If you don’t expect working capital to improve for 18 months, a 24+ month term loan could make a huge difference to your small business. The main thing is you don’t want to wait until you have negative working capital to apply for a business loan because you’d have a harder time getting it approved.
Apply for a Business Line of Credit
A business line of credit is like a cross between a business loan and a business credit card. You borrow what you need when you need the money and only pay interest on the amounts borrowed. As such, a business line of credit is an ideal way to meet potential cash shortages.
Say your working capital and liquidity ratios are a little low, but you still believe you can meet your financial obligations over the next year. In this case, it may be better to get a line of credit instead of an MCA or term loan. That way, you can borrow on the fly as when needed, and you won’t be stuck with the higher fees and interest that come with MCA and term loans.
The Bottom Line
In a perfect world, your working capital and liquidity ratios would always be strong, and you’d never have to borrow money to meet short-term financial obligations. But in reality, your business could run into trouble at some point – you never know when that might happen.
That’s why it’s important to use an online small business funding platform that connects small business owners to funding options and products that fit their needs, like Biz2Credit. We’ve provided over $7 billion in small business funding for more than 200,000 companies, including Saunders Landscape Supply. Don Saunders, the company’s owner, needed $50,000 to purchase inventory. We gave him repayment terms that were right for his business, and he saw a “significant increase in sales” after partnering with Biz2Credit.
Learn more about how Biz2Credit can help your small business meet its working capital needs.
FAQs
How does working capital impact liquidity?
Adequate working capital improves a business’s liquidity. Conversely, insufficient working capital leads to cash flow problems and negatively impacts a company’s financial health.
What is a good liquidity ratio?
In many cases, a liquidity ratio over 1 is recommended. But this ranges from business to business.
What’s the best way to calculate working capital?
Working capital is calculated by subtracting a company’s current liabilities from its assets.
Why are liquidity ratios important?
Liquidity ratios show how well a business can pay its debts and meet its short-term expenses. The ratios also show how much safety margin a company has to deal with unexpected expenses or slow sales.
Can a business loan be used to increase a company’s working capital?
Absolutely! If a business doesn’t have enough liquidity or cash on hand to meet short-term operational expenses, a loan can help.
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