Working capital: Meaning, ratios and importance

Working capital measures a business’s operating liquidity—it illustrates how much readily available cash and assets the business has to cover day-to-day expenses and keep operations running smoothly.

Maintaining a strong working capital ratio can help you avoid cash flow shortages, support business growth and more. Keep reading to learn how to calculate working capital, when to use it over other financial metrics and how to increase it.

What you’ll learn:

• Working capital measures a business’s liquidity and ability to cover its day-to-day expenses. It considers the business’s current assets and liabilities to give business owners an idea of their short-term financial health and operational efficiency. 

• There are three key liquidity ratios that evaluate working capital—quick, current and cash.

• Understanding working capital alongside other financial metrics, like cash flow and debt-to-equity (D/E) ratio, can help business owners make more-informed decisions.

• Some immediate practical steps you can take to increase working capital include restructuring debt, cutting out nonessential costs and optimizing processes.

Working capital is a financial metric representing the difference between a business’s current assets and liabilities. It is an indicator of a business’s short-term liquidity and operational efficiency.

If you can cover short-term bills and fund growth internally, it’s a sign of positive working capital and that the short-term health of your business is solid. In contrast, negative working capital indicates liquidity issues, which may lead to late payments, higher debt and financial strain.

To calculate your working capital, you’ll need information from your business’s balance sheet: specifically the business’s current assets and liabilities. 

The formula for working capital is:

Working Capital = Current Assets − Current Liabilities

Working capital is determined by assessing a company’s short-term assets and liabilities. These inputs help gauge whether a business has enough liquidity to manage its daily expenses and short-term obligations.

Assets are the resources that contribute to a business’s liquidity. Inputs for assets typically include:

• Cash and cash equivalents: These are any readily available funds the business has for immediate use.
• Accounts receivable: The outstanding money customers owe for goods or services already provided. Businesses should account for the potential portion of receivables that may not be collected.
• Inventory: The products or materials on hand that can be sold or used for production.
• Marketable securities: Any short-term investments that can be quickly liquidated.
• Prepaid expenses: Any payments made for future expenses, like rent or insurance premiums.

Liabilities are short-term financial obligations and typically include:

• Accounts payable: Money owed to suppliers or vendors for goods and services received.
• Debt: Loans or credit lines due within 12 months.
• Accrued expenses: Any costs incurred—but not yet paid—like wages, taxes and interest.
• Deferred revenue: Any payments received in advance for goods or services that haven’t yet been delivered.

The following is an example based on the most recent balance sheet of a small business, a local retail shop (LRS). The shop reported current assets of $85,000 and current liabilities of $50,000, giving it a working capital of:

$85,000 − $50,000 = $35,000

LRS’ current working capital of $35,000 represents an increase of $5,000 compared to three months earlier when the business’s working capital was $30,000. In this example, LRS’ working capital increased—meaning it has more liquidity to handle unexpected expenses or to reinvest in growth. 

For businesses like this one, monitoring working capital regularly can help ensure that they can pay suppliers on time, manage their inventory efficiently and avoid any cash flow shortages.

The quick ratio, also known as the acid-test ratio, looks at a business’s short-term financial health and liquidity by calculating the assets that can be quickly converted to cash, such as:

• Cash and cash equivalents
• Marketable securities
• Accounts receivable

Because this method excludes less-liquid assets like inventory, it can provide a clearer picture of whether your business can raise cash quickly without relying on inventory sales. You can calculate the quick ratio as follows:

Quick Ratio = (Current Assets − Inventories − Prepaid Expenses) /Current Liabilities

Consider the items on LRS’ recent balance sheet:

• Current assets: $85,000
• Inventories: $35,000
• Prepaid expenses: $10,000
• Current liabilities: $50,000

Now calculate the quick ratio:

Quick Ratio = ($85,000 − $35,000 − $10,000) / $50,000 = $40,000 / $50,000 = 0.8

A quick ratio of 0.8 means the business has $0.80 in liquid assets (excluding inventory and prepaid expenses) for every $1.00 of short-term liabilities. Since an ideal quick ratio is 1:1, the ratio shows that LRS may face potential liquidity concerns. They probably should explore options like improving cash flow management or reducing short-term liabilities. 

If the quick ratio tells you whether you can raise cash quickly, the current ratio gauges whether your business has a sufficient cushion to continue operations without facing liquidity issues. In contrast to the quick ratio, the current ratio considers all current assets, even those that may not be as easily converted into cash. You can calculate the current ratio as follows:

Current Ratio = Current Assets / Current Liabilities

Now let’s apply this to LRS’ balance sheet:

• Total current assets: $85,000
• Total current liabilities: $50,000

So the current ratio is:

Current Ratio = $85,000 / $50,000 = 1.7

A current ratio of 1.7 means that LRS has $1.70 in current assets for every $1.00 of current liabilities. What does this mean? It indicates that the business has enough assets to cover its short-term obligations—with a small cushion for potential unforeseen expenses or dips in liquidity. 

The cash ratio measures how well a company can cover its current liabilities using only cash and cash equivalents. Compared to the other ratios we’ve covered, the cash ratio is a more conservative calculation because it only focuses on the business’s most-liquid assets.

Creditors typically favor a higher cash ratio because it signals strong liquidity. However, holding too much cash may indicate an inefficient use of assets since idle cash doesn’t generate returns. Therefore, evaluating the cash ratio alongside other liquidity metrics is best for a complete financial picture.

The cash ratio is calculated as follows:

Cash Ratio = Cash and Cash Equivalents / Current Liabilities

Using the inputs from LRS’ balance sheet:

• Cash and cash equivalents: $20,000
• Total current liabilities: $50,000

The cash ratio is:

Cash Ratio = $20,000 / $50,000 = 0.4

This means LRS has $0.40 in cash and cash equivalents for every $1.00 of short-term liabilities. Since an ideal cash ratio is typically 0.5 or higher, this ratio suggests that LRS may need to rely on other current assets, like accounts receivable or inventory, in order to cover its short-term obligations.

We’ve established how working capital can serve as a key indicator of a business’s short-term financial health. But for a more comprehensive view, it’s important to consider working capital alongside other financial metrics. 

By complementing working capital with other financial metrics that provide insights into operations, profitability and financial stability, you can make better-informed decisions about managing your growing business.

Consider the following common financial metrics:

• Cash flow:
  • What it measures: If working capital measures short-term financial health, cash flow tracks actual cash movement. 
  • Real-life application: A business can have positive working capital but still experience cash shortages if receivables take too long to collect. Consider our original example: LRS has $35,000 in inventory and $15,000 in accounts receivable, contributing to its $85,000 in current assets. But what if customers delay payments and inventory takes longer to sell? In that case, LRS might struggle to pay its $50,000 in current liabilities on time, leading to cash flow issues—despite its positive working capital.
• D/E ratio:
  • What it measures: The debt-to-equity (D/E) ratio assesses a company’s reliance on debt for financing. A business may have positive working capital but still be heavily leveraged, meaning it might be taking on significant debt to fund its operations.
  • Real-life application: For example, LRS has $12,000 in short-term debt as part of its $50,000 in current liabilities. However, if LRS’ overall D/E ratio is high, lenders might view it as risky despite having sufficient working capital. This could make it harder for LRS to secure additional financing.
• EBITDA:
  • What it measures: EBITDA (earnings before interest, taxes, depreciation and amortization) measures a business’s profitability before considering nonoperating costs like taxes and depreciation. As a result, a company can show strong EBITDA but still have poor working capital if its assets aren’t easily liquidated.
  • Real-life application: Suppose that LRS reports strong EBITDA due to steady and climbing sales. But most of its working capital is tied up in $35,000 worth of inventory, making it hard to cover the $50,000 in short-term liabilities without quickly selling stock. If demand slows, LRS could face liquidity issues, even with solid EBITDA.
• Net income:
  • What it measures: Similar to EBITDA, net income reflects profitability or the bottom line. However, a business can be profitable but still struggle with working capital if its short-term liabilities outpace its liquid assets
  • Real-life application: Suppose LRS earns a monthly net income of $10,000, showing profitability. But because it has $50,000 in current liabilities, it may still struggle to cover short-term expenses if it can’t quickly convert inventory and receivables into cash.

Considering these financial metrics alongside working capital can unlock valuable insights, helping business owners make more-informed decisions that balance liquidity, profitability and financial stability.

Working capital helps businesses operate smoothly, manage risks effectively and position themselves for growth—so increasing it can be a smart move.

Here are three ways to start increasing working capital right now:

1. Refinance debt: One option is to refinance—extend the repayment period of short-term debt beyond one year. Converting debt into a longer term reduces your current liabilities and improves cash flow and working capital.
2. Cut nonessentials: Analyze business expenses to eliminate or reduce nonessential costs.  Consider streamlining operations to free up cash and boost working capital.
3. Optimize collection processes: Speed up the collection of outstanding invoices. How? Try implementing strategies like discounts for early payments. Set up automated reminders. Or even shorten customer credit terms. All of these strategies can reduce outstanding debts, enhance cash flow and increase your working capital. 

Working capital measures a business’s short-term financial health and liquidity. Three important liquidity ratios—quick, current and cash—evaluate working capital to provide comprehensive insights into a business’s financial stability. 

Monitoring and optimizing working capital alongside other financial metrics, like cash flow, D/E ratio and EBITDA, helps business owners make smarter, more-informed financial decisions. Improving working capital can be achieved by refinancing debt, cutting nonessential costs and optimizing processes to free up cash.

As a business owner, you might find unexpected short-term expenses and managing cash flow to be challenging. But a business credit card can help you manage these challenges with relative ease. You can check which Capital One business card you’re pre-approved for—without any impact on your credit—and find the card that suits your business’s financial needs.