What it means
Working capital is the difference between current assets (cash, receivables and inventory) and current liabilities (bills due within a year). It is the money tied up in running the business day to day.
The more of it a business needs, the more funding it must find. This ratio asks how much operating cash flow the business produces for each dollar of working capital.
A higher figure means the company generates plenty of cash from a modest working capital base. A lower figure suggests that a lot of capital is tied up for each dollar of cash produced.
For example, a ratio of 1.2 means the company generates $1.20 of operating cash for each $1.00 of working capital. A business with a ratio below 1 may need to look at how fast it collects receivables and turns over inventory.
Improving those areas can free cash without any new funding. The ratio is best used as a trend and in comparison with similar companies.
A sudden fall may show that working capital is building up, perhaps because customers are paying later or stock is piling up. A rise may reflect better efficiency or simply a cut in working capital caused by delaying payments to suppliers.
Care is needed when working capital is very small or negative. Supermarkets and subscription companies often run with negative working capital because they receive cash before they pay suppliers.
The ratio then becomes meaningless or negative, and other measures should be used. Seasonal businesses need extra care.
Working capital can swell before a peak season as stock is built up, which lowers the ratio at that point in the year even if the business is healthy. Comparing the same time of year across several years, or using an annual average, avoids drawing the wrong conclusion.
In practice
Real-world examples
Example 1
A machinery maker has operating cash flow of $600,000 and working capital of $1,500,000, a ratio of 0.4. The owners notice that this is lower than a competitor's 0.9. They investigate their slow-moving stock. They discover that part of the gap comes from holding too many spare parts, and they agree to reduce orders for slow items.
Example 2
A consulting firm has operating cash flow of $750,000 and working capital of $250,000, a ratio of 3.0. It needs little working capital to operate. Its partners can take out most of the cash each year. Because working capital is so small, the ratio looks very high, and the partners treat it with caution.
Example 3
A wholesaler improves collection times and cuts inventory, reducing working capital from $2,000,000 to $1,600,000, while operating cash flow stays at $800,000. The ratio rises from 0.40 to 0.50. The finance director reports that efficiency has improved.
Think of it
Cash flow to working capital shows how much cash you generate relative to working capital invested.
Formula
Calculation
Cash flow to working capital = Operating cash flow / Working capital
Working capital = Current assets - Current liabilities
Worked example: a company has operating cash flow of $480,000, current assets of $900,000 and current liabilities of $500,000.
Step 1: Working capital = $900,000 - $500,000 = $400,000.
Step 2: Ratio = $480,000 / $400,000 = 1.2.
The company produces $1.20 of operating cash for every $1.00 of working capital.Case study
Seen in the real world
Larkspur Toys is an illustrative, fictional company with operating cash flow of $300,000 and working capital of $1,000,000, a ratio of 0.3. Competitors of a similar size had ratios of around 0.6. The owners wanted to know why their business needed so much working capital.
A review found that stock was held for an average of 120 days and that customers took 70 days to pay. The company introduced a stock reduction plan and a prompt-payment discount. A year later, working capital had fallen to $700,000 and operating cash flow had risen to $350,000, lifting the ratio to 0.5.
The illustrative lesson is that working capital efficiency creates cash. Tracking the ratio gave the managers a clear way to measure progress. The managers now report the ratio twice a year, using average working capital, so seasonal swings do not confuse the picture.
Watch out
Common mistakes
- Using the ratio when working capital is close to zero or negative, where the result is distorted.
- Assuming a higher ratio is always good, when it can come from delaying supplier payments rather than real efficiency.
- Comparing companies in different industries with very different working capital needs.
Questions
People also ask
What is working capital?
It is current assets minus current liabilities, and it measures the short-term resources used to run the business.
Is this the same as the current ratio?
No, the current ratio divides current assets by current liabilities, while this ratio compares operating cash flow with the net working capital.
How can I improve it?
Collect receivables faster, cut slow-moving stock and negotiate fair supplier terms, all of which release cash. Each improvement should be checked to make sure it does not harm customer service.
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