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Current ratio and working capital.

   

Working capital and the current ratio measure the liquidity of your business - its ability to meet short-term debt with current assets.

Together, these are two of the most common measures of financial strength. The current ratio shows whether a company has sufficient access to cash to continue operations after paying off current liabilities. Working capital is the dollar amount by which current assets exceed current liabilities.

Respond to emergencies

It's important to maintain a margin of safety in liquid assets to handle potential emergencies. Inventory shrinkage, un-collectable accounts, or a debt that suddenly comes due may require you to rely more heavily on your current assets. Keeping a cushion helps you weather the inherent uncertainties of running a business. 

Access investment, growth, and expansion opportunities 

In addition, loans are frequently tied to minimum working capital and current ratio requirements. With a sound liquidity position, your company's chances of obtaining a loan increase.

What results are satisfactory?  

A current ratio of 2.0 is considered good for most industries. A higher ratio is generally an indication of a stronger financial position, and may mean there is cash available for the owner to withdraw. But there are exceptions; a high ratio can sometimes mask hidden financial problems. For instance:

  • an inventory backlog

  • slow collections on accounts receivable

  • recent sales of fixed assets

Any of these conditions may reduce the productive capacity of the business or indicate financial trouble. It's important to look at why your current ratio is high or low, as well as looking at the number itself. 

A low current ratio can also mean trouble. A ratio of 1.0 means that for every dollar owed, there is exactly one dollar available to pay it. This leaves you without any cushion - a risky situation indeed. A decline in the current ratio over time can be problematic as well. It may indicate that the company will not be able to meet its debt when that debt comes due. 

Like the current ratio, a higher working capital figure generally indicates a stronger financial position.

What business activities affect my results? 

Anything that increases or decreases current assets or current liabilities can affect working capital and the current ratio.

  • a buildup or decline in inventory or A/R

  • a change in available cash

  • a reduction in short-term debt

  • a backlog of bills to pay

The more quickly Inventory and Accounts Receivable can be converted to cash, the more secure your cushion. 

How can I gain better control over these results? 

Are Total Current Assets or Total Current Liabilities increasing? Decreasing? What caused the change? If you want to improve your current ratio, these things may help:

  • collect outstanding accounts receivable

  • pay off some current liabilities

  • convert fixed assets to cash: sell unused equipment

  • increase current assets with new equity investments

  • take fewer owner withdrawals and reinvest profits back into the business

  • increase your cash balance with a long-term loan

 

 

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