What Business Owners Must Know About Working Capital and Liquidity Ratios
In this article, you’ll learn:
- What working capital is
- What liquidity ratios are
- Why strong working capital and liquidity ratios 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. With that in mind, it’s important to have a sufficient amount of cash and other liquid assets on your balance sheet relative to your current liabilities.
By calculating your working capital and a few liquidity ratios, you can get a good idea of your small business’s ability to navigate short-term setbacks.
What is Working Capital?
Your working capital is your total current assets minus your total current liabilities. Your current assets include cash and cash equivalents, accounts receivable, and inventory – essentially anything you expect to be sold or used through operations within 12 months. Your current liabilities are calculated by adding up the amounts you have to pay creditors within 12 months – accounts payable, accrued expenses, notes payable, and taxes payable are a few current liabilities.
At the bare minimum, you want your current assets to exceed your current liabilities. If your current liabilities are greater than your current assets, you have a very high chance of running into cash flow problems over the next year.
So, how do you know if you have enough working capital?
It depends on your company size and industry. For some companies, $10,000 in net working capital is enough. But for others – perhaps bigger companies with unpredictable quarterly performance – $10,000 in net working capital is way too little.
Due to these company-to-company differences, your working capital ratio (current assets/current liabilities) is a better measurement of your financial health. In most cases, a ratio of between 1.5 and 2 means that your company is in good shape. Your working capital ratio, also known as your current ratio, is one liquidity ratio.
What are Liquidity Ratios?
Liquidity ratios are used to assess a company’s ability to pay off its short-term debt obligations without raising external capital. It might seem like your net working capital and working capital ratio tell you all you need to know, but consider this: what if all of your current liabilities are due in three months, and all of your company’s current assets won’t be turned into cash for at least six months? In this case, your working capital ratio could be 2 or 3 – usually a very healthy number – and you’d be in a bind.
We’ve already introduced the current ratio, but here are a few more common liquidity ratios to assess your company’s short-term financial health.
The quick ratio is your (cash and cash equivalents + marketable securities + accounts receivable)/current liabilities. This ratio strips out 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 a long time to collect receivables, which could impact your ability to meet short-term financial obligations.
Operating Cash Flow Ratio
The operating cash flow ratio is operating cash flow/current liabilities. This ratio measures how many times a company can pay its current debts with cash generated by operations over the same period of time.
Look at 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 is likely to have no problem meeting obligations.
And if one of the ratios is on the lower end, it doesn’t necessarily mean trouble for your business. Say you have a quick ratio of .75 – this is unhealthy in a vacuum. But 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
We’ve established that working capital and liquidity ratios are indicators of your small business’s ability to pay off its short-term debt obligations, but they are lagging indicators – since the future is impossible to predict, you don’t want 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
You only have to look back a little over two years to see that something completely unexpected can happen in an instant that changes your company’s fortunes. Say 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 like you weren’t going to have any problem 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 may have a significant impact on your working capital and liquidity ratios, depending on your type of business. And if you struggle to sell current inventory, you might struggle to meet short-term financial obligations if you don’t have enough cash on hand. The predictability of your inventory turnover depends on your industry – a small business that sells groceries has high predictability, while a small business 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 that is growing at a compound annual growth rate (CAGR) of 20% per year. You believe that you have the potential to 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… which require up-front investments.
How to Improve Your Working Capital and Liquidity Ratios
By now, you’re likely convinced of the importance of strong working capital and liquidity ratios, but what do you do if your ratios are on the lower end?
You have several options to boost your numbers. Here are some possibilities:
Take on Less Debt
This is easier said than done, but you might not really need everything you’re buying for your small business. By carefully considering the return on investment (ROI) of each business purchase, you make sure that you’re only buying what you need.
A really fast way to reduce your current liabilities, and as a consequence, improve your working capital and liquidity ratios, is to ask for longer repayment terms on your short-term financial obligations. While this might be the right option for your small business, you should make sure you’re not paying a much higher interest rate on the new loan.
Boost Net Income
Here’s one that’s way easier said than done: boost your net income. A higher net profit margin increases your cash position over time, which improves your working capital and liquidity ratios. There are several ways to boost net income, but in our current inflationary environment, you should consider raising prices, in particular.
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. In many agreements, the lump sum amount (plus fees) is due within a year. So, this financing option is typically suitable for a small business owner who 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 is good about MCAs: you may be able to qualify with a credit score of 525-550. 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.
For a new small business owner who has a can’t-miss idea, an MCA could work out very well. Say you want to run a $10,000 marketing campaign that you expect to directly lead to at least $50,000 in sales. In this case, an MCA might be the smart choice.
Use a Term Loan
Like a merchant cash advance, a term loan provides you with upfront cash… but that’s where the similarities end. With Biz2Credit, you can get a term loan with a payment plan of between 12 to 36 months and a loan amount between $25k and $500k. The rate is as low as 7.99%, making term loans a reasonably priced small business financing option. There are strict requirements – 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 who have long-term working capital needs. If you don’t expect working capital to improve for 18 months, for example, a 24+ month term loan could make a huge difference to your small business.
Use a Business Line of Credit
A business line of credit is like a cross between a business loan and a business credit card, as 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 assign an 80% chance of being able to meet your financial obligations over the next year. In this case, you might not want to get an MCA or term loan, as there’s an 80% chance the fees/interest would be paid for no benefit. With a line of credit, however, you have a safety net if the 20% downside risk comes to fruition.
The Bottom Line
In a perfect world, your working capital and liquidity ratios would always be really 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 loans and financing for more than 200,000 companies, including Saunders Landscape Supply. Don Saunders, the owner of the company, needed $50,000 to purchase inventory. We gave him repayment terms that were right for his business, and he ended up seeing a “significant increase in sales” after partnering with Biz2Credit.
Learn more about how Biz2Credit can help your small business meet its working capital needs.
Comments are closed.