What Is It & How Is It Calculated?
Working capital refers to the the capital/funds a business has on hand to manage and facilitate its day-to-day operational expenses. Generally speaking, the working capital of a business is calculated as Current Assets minus Current Liabilities. If this figure is negative, the business may have working capital issues.
Working Capital Ratios
Lenders will often calculate financial ratios in order to gage the health of a business’ working capital and in turn its ability to repay potential loans it may be applying for.
One such ratio, which is often used by lenders as one of the best measures of the liquidity of a business, is the “Quick Ratio” or the “Acid Test Ratio”. This ratio is calculated as follows:
This ratio demonstrates to lenders that if the business does not generate any income for a prolonged period of time, what its capacity would be to make potential loan repayments. If the ratio is 1:1, this means that the business would not have any further working capital after paying its bills.
Therefore in general terms, the higher the Quick Ratio the better. For example:
The above random example demonstrates a healthy Quick Ratio. If however the figures were reversed as follows:
Start panicking. This inverse example demonstrates a business that cannot pay its bills.
It is important to utilise the above discussed ratio in conjunction with other financial ratios (as well as your accountant’s advice) in context to your business and your industry specifically. Reason being, some businesses carry stock, some don’t (e.g. service businesses). Furthermore, businesses that carry stock may be able to convert it into cash much quicker than others. For example, coffee is very quickly converted to cash in a cafe however earth-moving equipment might not necessarily sell as quickly.
If you’re unsure as to your business’ capacity for borrowings, we are here to help. We can sit down with you and your accountant to discuss how you should approach a finance application.
So, please feel free to contact us should you wish to discuss your specific situation.
Disclaimer: The information provided herein is for general information purposes only and does not constitute specific advice. It should not be relied upon for the purposes of entering into any legal or financial commitments. Specific advice should be obtained from a suitably qualified professional before adopting any investment/financial strategy.