Working Capital Ratio

Why Goldilocks and the porridge are just right

I'm sure if we could sit down with Goldilocks and chat about the working capital ratio (no, really) it wouldn't be too long before we were discussing the need to relate it to something meaningful like porridge.

Working capital is the amount of money tied up in the short term / trading side of your business. In terms of accounting formulas you need:

Working Capital = Current Assets - Current Liabilities

You're still with me right? Back to Goldilocks then. Too little working capital would be like the porridge that was too hot - a bit dangerous and liable to give you a nasty burn if you weren't paying attention

Too much working capital would be the porridge that was too salty (or cold - depending on your recollection). While noone is going to get burned, it's not very sweet, and a bit of a waste really as it's not going to get eaten.

That is exactly what happens when you have too much working capital. You tie up extra money in production and/or warehousing and you end up with some unpalatable financing charges in your accounts as a result.

That leaves you, me and Goldilocks with the conundrum of what is just right. Like all great answers, it depends. Due to the differing nature, systems and product mix of every business, each will require different amounts of working capital

Working Capital Ratio = Average Working Capital / Year Sales

What does the ratio tell you then? It tells you that for every dollar of sales you need $0.x of short term funding in your business

For example if sales are $100,000 and average working capital is $18,450 then you need $0.185 per $1 of sale to feed your business. Yum.

This is useful because if sales are on an upward trend, then you know that you will need some funding from somewhere, and you can also work out roughly how much you need. You can plan in advance

Armed with this information, can you look at competitors and compare your results to theirs? Do they need less or more working capital than you? If they need less, then that's great for them, but what could you do about it to improve your requirements?

Using the working capital ratio, you can measure the results of changes you make in your day to day working capital management and whether your initiatives are working or not.

Top of Working Capital Ratio

More about Accounting Formulas

Using Financial Ratio Analysis to reduce working capital requirements.

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