Businesses could go bankrupt if they are not profitable, but that’s not the main cause. They go bankrupt because they run out of cash and can’t meet their payment obligations as they come due. Even profitable, growing companies can also run out of cash, because they need increasing amounts of working capital to support additional investment in inventories and accounts receivable as they grow. Reviewing the working capital can help you avoid this pitfall.
What is working capital?
Working capital is the money you need to support short-term operations. It is this focus on the short-term that distinguishes working capital from longer-term investments in fixed assets or research and development.
Working capital is the difference between current assets and current liabilities. The term current refers to the fact that these items fluctuate in the short-term, increasing or decreasing along with operating activities. Generally, these are assets that can be converted into cash within the next 12 months of the operating cycle, such as inventory and accounts receivable. Current assets include cash, short-term investments, accounts receivable and inventories.
Current liabilities include an operating line of credit from a bank, accounts payable, the portion of long-term debt expected to be due within the next 12 months, and accrued liabilities such as corporate income tax and GST/HST payable. All these items turn over and change in value on an ongoing basis.
The working capital ratio
The amount of current assets and current liabilities can be found on the company’s Balance Sheet for any given point in time. To assess the health of your business, you’ll need to monitor the working capital ratio, which is calculated by dividing total current assets by total current liabilities. For this reason, it is also commonly referred to as the current ratio. It is a measure of liquidity, meaning the business’s ability to meet its payment obligations as they fall due.
Here’s how the calculation works: Current assets / Current liabilities
In general, the higher the ratio, the greater your flexibility to expand operations. If the ratio is decreasing, you need to understand why. The ideal ratio depends on your industry and particular circumstances. If it is less than 1:1, this usually means you are finding it hard to pay bills. Even when the ratio is greater than 1:1, you may still experience difficulty depending on how quickly you can sell inventories and collect accounts receivable. A ratio of 2:1 usually provides a reasonable level of comfort.
You should also calculate the business’s operating cycle to find out how long it takes to sell inventories and collect accounts receivable. A business with a long operating cycle should have a higher working capital ratio.