Written by Stephen Beard, Managing Director of Plyo Bookkeeping, a Vancouver-based bookkeeping firm.

Introduction

Working capital is one of those business terms that everyone uses, but few people can define. There are also many variations such as operating working capital, quick ratio and the working capital ratio. In this blog post I’ll be discussing whether these are useful metrics for a small business, or whether they’re just business jargon that you can do without.

What Is Working Capital?

Working capital is an accounting metric which acts as a rough (and I mean very rough) proxy for your shorter-term liquidity. It’s a way of quickly checking whether your business has enough current assets (think cash, inventory, and accounts receivable) to cover your current liabilities (think accounts payable, salaries owed or short-term loans). The formula for working capital is straightforward:

Working Capital = Current Assets – Current Liabilities

The idea is that when it comes to running your business in the next 12 months (the usual time frame taken to mean ‘current’), you’ll need more current assets than current liabilities to be able to pay your suppliers and keep the lights on. This makes sense and explains why fixed assets are excluded from working capital. You can’t (and more importantly don’t want to) sell your long-term buildings and machinery just to pay the operating expenses of your business.

Is Working Capital too Simplistic?

Not all current assets and current liabilities were created equal, and this is one of the great problems with using working capital as a metric for running your business. Let’s look at an example.

You have current assets of stock $200k, cash $50k and accounts receivable $25k. You also have current liabilities of accounts payable $150k. On the face of it you have a positive working capital of $125k ($275k current assets less $150k current liabilities). But in the short run your stock is less liquid than the cash and accounts receivable. If your supplier is demanding payment of the $150k tomorrow, there would only be $50k of cash and possibly $25k from the accounts receivable (if they settle quickly). The business has positive net working capital, but may lack the cashflow to pay suppliers and staff.

You’ll commonly hear people say that monitoring working capital is essential for monitoring your company’s liquidity. This simply isn’t true. If you need to monitor your businesses liquidity, then you should be preparing a cash-flow statement, as this would have the required level of detail to predict whether or not you have sufficient resources to run your business.   

The Quick Ratio

While working capital isn’t very informative when looking at your business’s liquidity, one of its variants, the quick ratio (AKA the ‘Acid Test’), can help you monitor your short-term liquidity. The quick ratio is calculated as follows:

Quick Ratio = Quick Assets / Current Liabilities

Quick assets are short-term assets that can be turned into cash easily. These are things like cash and cash equivalents, marketable securities and account receivables. The idea is that if you had to pay for all your current liabilities in cold hard cash, then would you be able to do it?

A quick ratio of 1 or above means that you have the required cash to cover all your current liabilities. While this is clearly a good position to be in, it doesn’t mean that a quick ratio below 1 is a bad thing. For example, your primary current liability may be a 12-month loan from your bank. It doesn’t make sense to have enough liquid cash to cover the entire loan, after all the bank has an agreed repayment structure and is unlikely to demand payment in full and at once. Having enough cash available to repay your loan would entirely negate the point of having the loan. Again, a simple single ratio lacks the granularity to tell you meaningful information about the health of your business.

Modified Quick Ratio

As an accountant, I frequently use a modified version of the quick ratio when reviewing client’s accounts. It’s fast, easy and lets me quickly spot if there are any short-term cash-flow problems coming up. It’s calculated as follows:  

Modified Quick Ratio = Quick Assets / Quick Liabilities

Quick liabilities means only liabilities which are due very soon, usually within the next 30 days. This means that the ratio is now focused on your ability to pay short-term and upcoming liabilities with assets that can quicky be converted into cash. With this modified ratio, having a ratio of 1 or above is more important, and a ratio below 1 likely indicates cashflow insecurity.

Operating Working Capital

Operating working capital is another more focused metric. Where the quick ratio is looking at short-term liquidity, operating capital is looking at how much of the business’s resources are tied up in assets that relate primarily to the operation of the business. This definition normally excludes cash, and instead focuses on current assets such as inventory, accounts receivable and prepaid expenses. Qualifying current liabilities would be things such accounts payable and accrued expenses. The calculation is as follows:

Operating Working Capital = Operating Current Assets – Operating Current Liabilities

Generally a lower Operating working capital figure indicates that assets are being used efficiently. For example, getting your accounts receivable to pay quickly, keeping your inventory balance low and having good credit terms from suppliers would all reduce the Operating working capital figure. There is of course a fine line between efficiency and recklessness. Not having enough inventory to meet a spike in demand, or damaging supplier relationships by being late on payments are good for operating working capital and bad for business.

Working Capital Ratio

Our last metric is the working capital ratio, also known as the current ratio. This is another high-level metric that’s primarily aimed at seeing whether your business may have liquidity issues or may have too many underutilized assets sitting around. This is calculated as follows:

Working Capital Ratio = Current assets / Current Liabilities

A ratio of 1.5 to 2 is generally considered healthy. A ratio below 1 indicates potential liquidity issues, while a ratio above 2 could mean you’re not utilizing your assets effectively.

Conclusion

For the average small business owner, the standard working capital figure is not very helpful. The same can be said for the quick ratio, though this can be modified to provide a convenient and fast way of checking for potential cash-flow problems in the near future.

The reality is that these ratios are more commonly used by investors, who have to quickly assess many different sets of company accounts. With access to industry standard benchmarks, a sophisticated investor can use these metrics to efficiently review multiple deal opportunities.

From the investor community, working capital has entered the common parlance of business. But for most small business owners, these metrics lack the granularity and nuance required to actually run their business. If you need to understand whether you have adequate cashflow to cover any short-term costs coming up, a cashflow is far more insightful than monitoring your working capital metric.