What it means
Net working capital is current assets minus current liabilities, and it represents the money tied up in running the business that is not already claimed by short-term creditors. Funded debt is the long-term borrowing that has to be serviced out of future trading.
Putting one over the other links the permanent financing burden to the working liquidity available. The result is read as a multiple.
A ratio below 1.0 means net working capital is larger than funded debt, which is generally treated as conservative, while a ratio well above 1.0 suggests the company leans heavily on long-term borrowing relative to its liquid base. Traditional lending practice often used a benchmark of around 1.0 for manufacturers and distributors, though sensible thresholds vary enormously by sector.
A supermarket chain runs on deliberately negative working capital because it sells for cash and pays suppliers later, so the ratio is meaningless or misleading there. The measure is most useful for inventory-heavy and receivables-heavy businesses, where working capital genuinely represents a stock of value that could be converted to cash.
It is far less useful for asset-light service firms, whose value sits in contracts and people rather than in the current asset section of the balance sheet. Two warnings apply in practice.
The ratio goes strange or negative when net working capital is small or negative, and it can be flattered by stale inventory and old receivables that will never turn into cash at book value.
In practice
Real-world examples.
Example
A machine tool distributor applying for an equipment loan shows a ratio of 0.7, comfortably inside its bank's guideline. The credit officer approves the facility quickly because the liquid asset base more than covers existing long-term borrowing.
Example
A building products supplier watches the ratio climb from 0.9 to 1.8 over two years as it funds a depot expansion with term debt while receivables collection slows. The board responds by tightening credit control before the next covenant test rather than after it.
Example
A restaurant group calculates the ratio and gets a negative number, because it holds almost no inventory and pays suppliers on thirty day terms while taking cash daily. Its finance team drops the measure and monitors interest cover and rent cover instead.
Think of it
“This ratio compares your long-term debt to your short-term cushion-are they balanced?
Formula
Calculation
Funded debt to net working capital ratio = Funded debt / (Current assets - Current liabilities).
A speciality chemicals distributor reports current assets of $9,500,000, made up of inventory, receivables and cash, and current liabilities of $5,500,000 covering trade payables, accruals and its overdraft.
Net working capital = $9,500,000 - $5,500,000 = $4,000,000.
Funded debt, consisting of a term loan and long-term lease obligations, totals $6,000,000.
Ratio = $6,000,000 / $4,000,000 = 1.5.
Long-term borrowing is therefore one and a half times the liquid cushion. Against a conventional benchmark of 1.0, a lender would ask how the company plans to repay, and would probably look closely at how much of the $4,300,000 of inventory inside current assets is genuinely saleable at full value.Case study
Seen in the real world.
Marlow Tile Company is an illustrative and clearly fictional importer of ceramic tiles used here to show the ratio in action. It carried funded debt of $5,000,000 against net working capital of $5,200,000, giving a ratio of about 0.96 and a comfortable conversation with its bank each year.
Trading then softened, and rather than cut purchasing the company kept ordering to protect supplier discounts. Inventory rose from $4,000,000 to $6,500,000, funded by an increased overdraft, so current liabilities rose alongside current assets and net working capital slipped to $2,500,000. The ratio moved to $5,000,000 divided by $2,500,000, or 2.0, and breached the covenant.
The bank did not withdraw support, but it required monthly inventory ageing reports and a written stock reduction plan. Over the following year the company cleared discontinued ranges at a discount, took a small margin hit and brought the ratio back to 1.2. The story is fictional, and its point is that the ratio deteriorated because of an operating decision long before it appeared as a financing problem.
Watch out
Common mistakes.
- Calculating the ratio for a business with negative net working capital and treating the resulting negative number as if it were meaningful.
- Taking current assets at book value without questioning slow-moving inventory and receivables that are months overdue.
- Applying a single benchmark across industries, when acceptable levels differ sharply between a distributor, a retailer and a consultancy.
Questions
People also ask.
What counts as a good ratio?
Many lenders to inventory-based businesses look for 1.0 or lower, but the right level always depends on the sector and on how quickly working capital converts to cash.
Should the current portion of long-term debt be included?
It is already inside current liabilities and so reduces net working capital, and including it in funded debt as well would count the same obligation twice.
How often should it be monitored?
Quarterly is normal for internal review, and monthly is sensible for seasonal businesses where working capital swings widely through the year.
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