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How working capital works

Working capital is current assets minus current liabilities. With $600,000 of current assets and $400,000 of current liabilities it is $200,000, the dollar gap behind a 1.50 current ratio. The current ratio is the same comparison as a multiple.

Current ratio

1.50

Take out $160,000 of inventory and the quick ratio is 1.10.

Quick ratio, inventory removed
1.10
Gross profit
$700,000
Gross margin
35.00%
$

Everything due to become cash within a year: cash, receivables, inventory, prepayments.

$

Everything falling due within a year, including the next twelve months of loan repayments.

$

Stock on hand. It sits inside current assets, and it is what the quick ratio takes back out.

$

The top line of the income statement. A full year here, and the same period in the line below.

$

The cost that only exists because the sale happened, over the same period as revenue. Wages, rent and marketing sit below it.

On this page

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Cash ratio

In short

  • Working capital is current assets minus current liabilities. $600,000 minus $400,000 is $200,000. The current ratio on that sheet is 1.50.
  • The same $200,000 on a software-shaped sheet with no inventory still sits behind a 1.50 current ratio and a 1.50 quick ratio. The dollar gap did not change. What it is made of did.
  • A grocer with $900,000 of current assets against $450,000 of bills has $450,000 of working capital and a 2.00 current ratio, and a 0.50 quick ratio once $675,000 of stock comes out.
  • Growth consumes it. Stock and wages leave before customers pay, so a profitable rising sales line can still drain cash.
  • How the current ratio works is the multiple. This page is the subtraction.

The same comparison as a subtraction

Working capital is current assets minus current liabilities:

Working capital=CA−CL\text{Working capital} = CA - CL

On $600,000 of current assets against $400,000 of current liabilities it is $200,000. Divide instead of subtracting and you have the current ratio, 1.50. Both are read off the balance sheet on its closing date.

The ratio travels better between companies of different sizes, which is why it is the one that gets quoted. The dollar gap is what actually has to be funded. A firm twice as large with the same 1.50 ratio has twice the working capital, and twice the cash tied up in the cycle.

The current ratio calculator on this page prints the multiple, the quick ratio, and the gross margin so a liquid wholesaler is not confused with a high-margin firm that happens to share a current ratio. This page is the subtraction behind the first of those.

What liquidity means is the wider idea. How the current ratio works is the multiple.

What it is made of matters more than the total

Take inventory out and you have the quick reading. On the wholesaler, $160,000 of inventory comes out of the $600,000, so the quick ratio is 1.10. Working capital is still $200,000. The stock is inside the dollar gap. It is not extra to it.

A software-shaped sheet with $0 inventory keeps the $200,000 of working capital and prints a 1.50 current ratio and a 1.50 quick ratio. Same gap, different firm: almost none of that $200,000 has to be sold to a customer before it can meet a bill.

A grocer with $900,000 of current assets against $450,000 of bills has $450,000 of working capital and a 2.00 current ratio, the strongest multiple on this page. $675,000 of that is stock. The quick ratio is 0.50. 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 warning.

Current ratio against quick ratio is that split in a table.

Growth consumes it

A company doubling its sales has to buy stock and pay staff before its customers settle. Cash leaves months before it comes back. That is how a profitable, fast-growing business runs out of money, and it is why an increase in working capital is subtracted when profit is turned into free cash flow, while a fall in it is added back.

The cash conversion cycle is this same loop written in days rather than in dollars: days sales plus days inventory, minus days payable. A longer cycle on a larger sales number consumes more cash next year than this year, even if the dollar working capital on last year's closing date looked fine.

More is not automatically better. A large positive figure can mean a sensible buffer, or it can mean warehouses of unsold stock and invoices nobody has chased. Some strong businesses run it negative on purpose: supermarkets and subscription firms collect from customers before they pay suppliers, so customers fund the day-to-day operations.

A closing date is a photograph

Balance sheet ratios are measured on a single date the company knows in advance. Settling short-term bills early raises a current ratio that is already above 1, and lowers one already below 1, with no change in the trading behind it. Working capital on that date moves with the same trick.

Compare the figure with the same firm a year ago, and with firms doing the same work. A $200,000 gap that has fallen from a much larger number in four quarters says something. The same $200,000 read cold says almost nothing until you know what the company sells.

Banks and insurers order the balance sheet by liquidity and publish no current total, so there is no working capital figure of this form to read off one.

The cash conversion cycle is the same loop in days

Working capital is a stock on a date. The cash conversion cycle is how long that stock takes to turn. 45 days of receivables plus 60 days of inventory minus 30 days of payables is a 75 day cycle. For 75 days, on average, the operations have cash stuck in the loop.

An increase in the cycle consumes cash. A fall in it releases cash. That is the same statement as 'working capital rose' or 'working capital fell', written in days so two firms of different sizes can be compared. The cash conversion cycle calculator is that identity. The cash conversion explorer is the three clocks as a bar you can drag.

What this page is not doing

It is not a cash forecast, not a current-ratio rule of thumb, and not a claim that more working capital is safer. The three sheets are $200,000 behind a 1.50 current ratio on the wholesaler, the same $200,000 on a software-shaped sheet with no inventory, and $450,000 behind a 2.00 current ratio on a grocer whose quick ratio is 0.50. 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?

  1. Current ratio is current assets over current liabilities: 600,000/400,000=1.50600{,}000 / 400{,}000 = 1.50.
  2. Take the inventory out to get the quick assets: 600,000−160,000=440,000600{,}000 - 160{,}000 = 440{,}000.
  3. Quick ratio divides that by the same liabilities: 440,000/400,000=1.10440{,}000 / 400{,}000 = 1.10.
  4. Gross profit is revenue minus the cost of goods sold: $2,000,000 minus $1,300,000 is $700,000.
  5. Gross margin is gross profit over revenue: 700,000/2,000,000=0.35700{,}000 / 2{,}000{,}000 = 0.35, 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, current assets minus current liabilities, 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?

  1. The current ratio is identical: 600,000/400,000=1.50600{,}000 / 400{,}000 = 1.50.
  2. Nothing comes out for inventory, so the quick ratio is the same 1.50.
  3. Gross profit is $2,000,000 minus $300,000, which is $1,700,000.
  4. Gross margin is 1,700,000/2,000,000=0.851{,}700{,}000 / 2{,}000{,}000 = 0.85, 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 still $200,000, because the current lines did not move.

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.

  1. Current ratio: 900,000/450,000=2.00900{,}000 / 450{,}000 = 2.00, the strongest reading on this page.
  2. Quick assets are what is left once the stock comes out: 900,000−675,000=225,000900{,}000 - 675{,}000 = 225{,}000.
  3. Quick ratio: 225,000/450,000=0.50225{,}000 / 450{,}000 = 0.50, the weakest reading on this page.
  4. Gross profit is $5,000,000 minus $3,900,000, which is $1,100,000.
  5. Gross margin is 1,100,000/5,000,000=0.221{,}100{,}000 / 5{,}000{,}000 = 0.22, 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, equal to the current liabilities on this sheet, because the current ratio is 2.00.

Common questions

Is working capital the same as the current ratio?

They are the same comparison written two ways. Subtract and you have dollars. Divide and you have a multiple. The dollars are what has to be funded. The multiple is what travels between firms of different sizes.

Can working capital be negative?

Yes. Current liabilities larger than current assets produce a negative gap. Some retailers and subscription firms run that on purpose, because they collect before they pay. In a manufacturer holding slow stock, the same negative figure is a bill-paying problem.

Why does growth eat working capital?

Stock and wages leave before customers pay. Double the sales and you usually double that timing gap in dollars, even if the current ratio does not move. That extra cash has to come from somewhere.

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.