While profit can seem to be the most important number in your financial statements, working capital makes sure your company will continue operating because it’s necessary to pay off current liabilities, seize growth opportunities, and protect your organization against risk.
In this article, we’ll explore what working capital is, why it's more important than profit, and how to interpret it.
Defining working capital and profit
Working capital is the money that a business uses on a day-to-day basis to cover short-term obligations. Now, let’s dive into its counterpart: profit. Profit is the excess money or surplus made after you deduct all your expenses, including the original cost of what you invested or purchased. This is the amount that'll keep your owners and investors happy.
Distinguishing between working capital and profit is key to financial management and understanding your overall financial position. Working capital is liquidity-based and the heartbeat that carries your organization through the day-to-day functions. Working capital isn't as manipulated through strategic accounting as profit is. On the other hand, profit is about strategic financial manipulation. It's about decision-making, lean cost management, and the successful execution of business initiatives. Your profit can be multiple different amounts. It depends on what method of accounting you choose, and the basis: tax, cash, or accrual. While working capital is the king of daily transactions, profit is the reward of a well-oiled and strategic accounting strategy.
See the difference?
How do you calculate working capital?
Working capital is calculated by taking your current assets and deducting your current liabilities. Current assets are assets that can be converted to cash within one year and current liabilities are liabilities that are due within one year.
For example, a calculation could be if you have $800,000 in current assets made up of cash and accounts receivable, and $600,000 of current liabilities made up of salaries payable and accounts payable (more on AR vs APhere), you'd have $200,000 in working capital. To convert this into a ratio, simply divide your current assets by your current liabilities. In this case, your working capital ratio would 1.33.
Now you know how to calculate it, but what does that number or ratio even mean? Being able to decipher this ratio is key to understanding your financial health.
Typically, a ratio of around one or above is a good sign. A ratio of one means that for every current liability you owe, you have a current asset to cover that.
But be cautious not to have a ratio too high above one because that'll mean that you are too liquid and not taking full advantage of your capital and investing it. A ratio of below one is a red flag that can signal that you don't have enough assets to cover your liabilities as they come due.
Why does working capital matter?
Imagine a small organization named Blue Beach that has ten employees, a few suppliers that sell them the items necessary to make beach toys, and a loan for their business. Blue Beach has always technically made a profit which they reinvested into machinery, but over the winter months, they had a decrease in sales and their expenses stubbornly remained the same.
They still have to pay their employees' salaries, their loan payments, and their suppliers under contract. Without enough working capital, Blue Beach may go under before the next beach season. Working capital may be even more important for a small business because they have less credibility and it's harder to fundraise. The absence of working capital as a buffer can make a short-term lull turn into bankruptcy.
Working capital is especially important for small to medium-sized businesses compared to larger corporations where fundraising is easier. As a reminder, working capital is the capital that keeps an organization running day-to-day.
Why is working capital more important than profit?
Everyone’s favorite accounting term is profit, but it may not be the most important. Here are three reasons why:
Paying off current obligations
The first is that it’s necessary to pay off current liabilities and expenses to keep the business running. This is almost one of the most important pillars. These are obligations such as suppliers, short-term debt payments, and payroll.
Picture the web your business is in and how many resources you need to operate and pay for in just a day or even a month. You can imagine how quickly your business would collapse without your inventory, running water, electricity, or even space to operate in. Or how fast banks and investors would be knocking on your door for the interest and debt payments you owe. They're usually not too friendly about missing those payments and the financial world doesn't have a reputation for leniency.
Missing payroll? Good luck keeping any employees, as few will be willing to work for free. Without these current obligations being satisfied on time, you won't be able to continue to making a profit.
Growth and expansion
The second reason is to be able to take advantage of opportunities as they come your way. This is where you have to be in your entrepreneurial mindset. Every entity has opportunities that come to them, and the ones that you can seize are the ones that have enough working capital to take advantage of.
Occasionally with these opportunities, you may not reap the rewards right away or need time to implement them, so you need working capital to sustain your entity for the time being. For example, if you want to hire that Golden Goose employee, you'll eventually see the benefits, however, you need to get through the learning curve, and completely train them which can take months and is expensive.
Another opportunity you need working capital for is to take advantage of a vendor discount, which typically requires you to either purchase in bulk or to pay sooner than your typical payment terms. But in the long run, this can save you some money.
Hiring a consultant is another way to improve your organization from time to time. You can use them to help strategically, improve automation, and be a short-term extra hand for larger projects, but like your day-to-day employees will want to be paid on time. You need working capital to get skin in the game if an investment pops up.
Risk mitigation
Finally, you need working capital for risk mitigation. The significance of working capital extends beyond your typical day-to-day periods of economic downturns are where you'll need working capital more than profit. Your working capital will become a lifeboat to sustain your entity through the hard times.
You can imagine how difficult it'd be to make it a full year with a small working capital reserve. It'd likely result in your company making layoffs, and cutting down on suppliers, all of this causing a chain reaction.If you need a loan, the lenders will look at your working capital and determine your rate and the amount they approve you for based on their determination of whether you'll be able to pay them back, so liquidity is a must. Sure, a nice profit doesn't hurt in their eyes either.
When seeking a loan, it's a balance between your profit and working capital that lenders will use to determine how healthy of a heartbeat your entity has.
How to decipher your working capital ratio
Now that you have your working capital ration you may be wondering what to make of it. Here are three ways to interpret what it means:
Industry benchmarks
First, you can use industry benchmarks. These are when you compare your organization’s working capital ratio to your industry’s standard. This will allow you to understand where you stand within your industry.You can find industry benchmarks through financial databases or financial journals such as Bloomberg.
Depending on the industry, governments will provide industry-specific benchmarks through the census or other government statistics sites. If you are a part of a membership for your industry, they should provide that as well.
For example, as a CPA, I can look at the AICPA for trends and financial data about accounting. My favorite places to search are within public filings, so looking at a public company's 10-k or online finance sites such as Yahoo Finance.
Once you find your industry’s working capital ratio benchmark, ask yourself these questions: What is the typical ratio for organizations doing similar work? Do they have massive amounts of liquid assets or is it generally tied up? Low amounts of liabilities or is it normal within your industry to have a lot of short-term liabilities? As I said before, a working capital ratio around one is typical, but not applicable for everyone.
Historical benchmarks
Another approach you can try is internal historical benchmarks. You can compare previous quarters, years, and months, to your current working capital ratio to understand if you’re doing better or worse, and most importantly, why you’re performing at that level. If your ratio changes, it's important to conduct a variance analysis along with an explanation as to why these changes are occurring.
For example, during COVID-19, many companies had a decrease in sales and they can document that the reason was COVID-19 interrupting in-person sales, supply chains, and restricting in-person work.
Essentially, using historical benchmarks can help you understand the history or story of your finances and ratios. You can analyze what quarters are higher for your working capital, or where you need to leave more. You can see which years you had the highest as well, and analyze why that is. Was there a popular trend? Did you have fewer employees? Less current obligations in general?
Comparative analysis
One more useful approach is comparative analysis. This is when you compare your organization to similar companies within your industry. For example, Coca-Cola compares well with Pepsi, but a small niche beverage company will have a better comparison with another company of a similar size. Finding these can be difficult if you are a small to medium-sized business.
There are a couple of ways to find out, however. Depending on how large your industry is, some services research benchmarking data you can purchase. Typically, small to medium-sized organizations protect their financial data, so this approach can be more difficult to use. I recommend this much more for public companies, as you can find this ratio on public filings or through sites such as Yahoo Finance. One important factor to note is you need to compare to an entity with the same accounting method or you won't be getting the information you think you are.
There's no one-size-fits-all on how to analyze and interpret your working capital ratio, so try industry benchmarks, internal benchmarks, and comparative analysis to see what works best for your organization.
Working capital over profit
Working capital is often overshadowed by profit. But to make a profit, you need working capital to pay off upcoming expenses, take advantage of opportunities, and minimize risk, or there won’t be an organization to make a profit.
Deciphering your working capital is key to understanding your company’s financial health—whether you do it by comparing industry benchmarks, historical benchmarks, or comparative analysis.
Put your working capital to work with Ramp
You’ve worked hard to increase your working capital. Now, consider using Ramp to:
- Improve your team's productivity. Give your teams the tools they need to automate tedious expense reports and close books 8x faster.
- Consolidate your tools. Don’t use two tools when one will do. With Ramp’s AI-powered bill payments and reimbursem*nts, you don’t need Expensify or Bill.com.
- Cut wasteful spending. Get insights on where you could be saving. Save on software costs with the help of our expert contract negotiators and price intelligence.
Learn more about how Ramp can help you manage your working capital.
