Working capital vs current ratio
Working capital is current assets minus current liabilities. The current ratio is the same comparison written as a multiple. On $600,000 of current assets against $400,000 of bills they read $200,000 and 1.50. The dollars are what has to be funded. The multiple travels between firms of different sizes.
| Working capital | Current ratio | |
|---|---|---|
| Formula | Current assets minus current liabilities. | Current assets / current liabilities. |
| Wholesaler sheet | $200,000. | 1.50, from $600,000 over $400,000. |
| Software-shaped sheet | Still $200,000. The current lines did not move. | Still 1.50, and the quick ratio matches it because inventory is $0. |
| Grocer sheet | $450,000. | 2.00, from $900,000 over $450,000. Quick ratio 0.50 once stock comes out. |
| What it is for | How many dollars are tied up in the cycle. | How the coverage compares across firms of different sizes. |
| What growth does | Usually raises the dollar gap even if the multiple does not move. | Can sit still while the dollars double, which is why the multiple alone misses the cash drain. |
On this page
Subtract or divide, then read both
The two figures are one comparison. Subtract and you have the cash that has to be funded. Divide and you have a multiple that travels. A firm twice as large with the same 1.50 current ratio has twice the working capital, and twice the cash tied up in stock and invoices.
On the grocer, working capital is $450,000 and the current ratio is 2.00, the strongest multiple on this page. Three quarters of the current assets are stock, so the quick ratio is 0.50. The dollar gap looked comfortable. The stock inside it is the whole story.
How working capital works is the subtraction. How the current ratio works is the multiple. Current against quick is inventory coming out.
A closing date is a photograph
Both figures are measured on a date the company knows in advance. Settling bills early moves them with no change in the trading behind it. Compare each with the same firm a year ago, and with firms doing the same work. This is educational material, not financial advice.
Worked examples
A wholesaler, all three ratios
A distributor holds $600,000 of current assets, of which $160,000 is inventory, against $400,000 of current liabilities. Over the year it sold $2,000,000 of goods that cost $1,300,000 to buy. What do the three ratios read?
- Current ratio is current assets over current liabilities: .
- Take the inventory out to get the quick assets: .
- Quick ratio divides that by the same liabilities: .
- Gross profit is revenue minus the cost of goods sold: $2,000,000 minus $1,300,000 is $700,000.
- Gross margin is gross profit over revenue: , which is 35 percent.
The current ratio is 1.50 and the quick ratio is 1.10, so the next year of bills is covered either way you count. Gross margin is 35 percent, meaning $700,000 of the $2,000,000 in sales is left over to pay wages, rent and everything else that is not the cost of the goods themselves Working capital is $200,000.
Same liquidity, a completely different margin
A software company reports the same $600,000 of current assets and $400,000 of current liabilities, but holds no inventory at all. It bills $2,000,000 a year, and its cost of goods sold, mostly hosting and customer support, is $300,000. How does it compare with the wholesaler?
- The current ratio is identical: .
- Nothing comes out for inventory, so the quick ratio is the same 1.50.
- Gross profit is $2,000,000 minus $300,000, which is $1,700,000.
- Gross margin is , which is 85 percent.
Both liquidity ratios read 1.50, because there is no inventory to strip out. Gross margin is 85 percent against the wholesaler's 35 percent on the same $2,000,000 of sales. Neither company is better run than the other. One buys goods and resells them, the other writes code once and sells it many times, and the margin is mostly telling you which is which Working capital is $200,000.
Liquid on paper, not once the stock comes out
A grocery chain holds $900,000 of current assets against $450,000 of current liabilities, which looks comfortable next to both companies above. But $675,000 of that is stock sitting on the shelves. Revenue is $5,000,000 and the goods cost $3,900,000.
- Current ratio: , the strongest reading on this page.
- Quick assets are what is left once the stock comes out: .
- Quick ratio: , the weakest reading on this page.
- Gross profit is $5,000,000 minus $3,900,000, which is $1,100,000.
- Gross margin is , which is 22 percent.
The same company scores 2.00 on the current ratio and 0.50 on the quick ratio. Three quarters of its current assets are groceries, so the bills falling due in the next year are twice the quick assets standing behind them. For a grocer that sells its stock in days and pays suppliers later, this is ordinary. In a firm holding machine parts that turn over once a year, the identical 0.50 would be a real warning Working capital is $450,000.
Common questions
Which one should I quote?
The multiple to compare firms of different sizes. The dollars to ask how much cash the cycle actually ties up. A rising sales line with a flat current ratio is often a rising working-capital bill.
Can they disagree in direction?
They cannot disagree in sign on the same date: a current ratio above 1 is positive working capital. They can disagree in what they emphasise. The grocer's 2.00 looks strong and its $450,000 is mostly stock.
Where does the cash conversion cycle fit?
It is the same loop in days. How the cash conversion cycle works is that identity.
Keep reading
This page is educational material, not financial advice. The figures come from the formula shown and assume the inputs you enter hold for the whole term. Your own rate, fees, taxes and timing will differ, so treat the output as arithmetic to check a decision against, not as a recommendation.