Last Updated May 30, 2024

When it comes to working capital management, it’s important to understand the various working capital metrics that can help you better understand the overall health of your business. While your net working capital is a helpful measurement on its own, digging deeper into additional working capital performance metrics will give you a more complete picture.

## What Does Working Capital Measure?

Working capital measures the difference between your current assets and current liabilities. It is a way of measuring your business’s liquidity—or the cash and other assets that are readily available to cover your financial obligations.

While there is no one-size-fits-all rule for how much working capital a business needs, it is recommended that businesses have a working capital ratio of 1.5 to 2.0—meaning their current assets are worth up to twice as much as the total of their current liabilities. If a company has negative working capital or a working capital ratio of less than one, it may struggle to meet its financial obligations.

It can be especially helpful to track changes in working capital over time so you can identify trends in your business performance.

## How to Calculate Your Working Capital

Measuring working capital is quite straightforward. You add up your total current assets, such as cash, accounts receivable, and cash equivalents. Then, you subtract the total of your current liabilities, such as payroll and taxes.

The formula for calculating your working capital looks like this:

Working Capital = Current Assets – Current Liabilities

## Working Capital Metrics

Beyond knowing how to measure working capital, keeping track of some key metrics will help you better understand how to determine working capital needs. The following working capital metrics should be a key consideration when evaluating your business’s overall performance.

### Current Ratio

The current ratio, also known as the working capital ratio, is a useful metric for determining if you have enough working capital to cover your financial obligations. To calculate this ratio, you divide current assets by current liabilities. The result is your current or working capital ratio. Most businesses should strive for a current ratio between 1.5 and 2.0 to ensure they have enough to cover expenses while also investing in growth opportunities.

Current Ratio = Current Assets / Current Liabilities

### Quick Ratio

The quick ratio, which is also sometimes known as the liquidity ratio, is a stricter measurement than the current ratio. When measuring assets, the quick ratio only includes cash, accounts receivable, and cash equivalents such as marketable securities. Essentially, the idea is that only including cash and assets that can quickly be exchanged for cash gives a better idea of a company’s ability to meet immediate financial obligations.

Quick Ratio = (Cash + Cash Equivalents + Receivables) / Current Liabilities

### Cash Ratio

The cash ratio is an even stricter liquidity measurement for determining working capital needs. The cash ratio only includes cash and cash equivalents, because they are a company’s most liquid assets that could be used to pay off immediate liabilities.

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

### Inventory Turnover Ratio

The inventory turnover ratio is used to calculate the average number of days it takes to sell your business’s inventory. It is a way of measuring how efficiently your company uses its assets and can influence marketing and pricing decisions. A ratio that is too low could indicate you have poor sales or have built up excess inventory. On the other hand, while high ratios typically indicate strong sales, they could also result from not keeping enough inventory in stock.

It is calculated using the cost of goods sold (COGS) and the average value of your inventory.

COGS = Beginning Inventory + Purchases – Ending Inventory

Once you know your COGS, you can calculate the inventory turnover ratio:

Inventory Turnover Ratio = COGS / Average Value of Inventory

### Working Capital Turnover Ratio

The working capital turnover ratio measures how efficiently a business is able to use its working capital to support its sales efforts and generate revenue. The higher the ratio, the more efficient a company is at using its working capital.

Working Capital Turnover Ratio = Net Annual Sales / Average Working Capital

### Days Sales Outstanding

Days sales outstanding (DSO) measures the average number of days it takes for your business to collect revenue after a sale is made. Calculating your DSO requires two formulas.

First, to calculate your average accounts receivable, find the average of your receivables for the period you are measuring:

(Beginning Receivables + Ending Receivables) / 2 = Accounts Receivable

Then to calculate your days sales outstanding, use this formula:

DSO = (Accounts Receivable / Net Credit Sales) x 365

### Days Inventory Outstanding

Days inventory outstanding (DIO) measures the average time it takes to convert your inventory into finished products that can be sold to customers. It is measured using your average inventory and the cost of goods sold (COGS).

Average inventory is calculated as:

Average Inventory = (Starting Inventory + Final Inventory) / 2

Once you have your average inventory and COGS measurements, you calculate your days inventory outstanding with this formula:

DIO = Average Inventory / COGS

### Days Payable Outstanding

Days payable outstanding, or DPO, measures the average number of days it takes for your business to pay suppliers for purchases. You first calculate your average accounts payable using the beginning and ending payables numbers from your working capital statement.

Average Accounts Payable = (Beginning Payables + Ending Payables) / 2

With this, plus your COGS calculation, you can determine your days payable outstanding with the following formula:

DPO = Average Accounts Payable / (COGS / 365)

### Cash Conversion Cycle

The cash conversion cycle, also known as the working capital cycle or net operating cycle, is based on your DSO, DIO, and DPO. It measures how many days it takes for your company to convert inventory and other resources into cash flow. The net operating cycle can vary between industries, so it is most helpful to compare your results to others in your niche. This will help you determine if you have an efficient cash conversion cycle or if you need to make improvements to areas like inventory management and marketing. The fewer days to convert, the better.

Cash Conversion Cycle = Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payable Outstanding (DPO)

## Other Ways to Manage Your Working Capital

There are other ways to manage and improve working capital that can help you become more efficient, regardless of your business’s size or niche.

### 1. Use Electronic Payables and Receivables

Even in the digital age, many companies continue to rely on manual processing for accounts payable and receivable. Switching to automated electronic processes for accounts payable and receivable can improve a business’s cash conversion cycles and make overall working capital management more efficient. Simply sending invoices more quickly with electronic systems can provide more working capital by facilitating faster payments.

### 2. Improve Invoice Management

How you manage client invoices can significantly impact your working capital. Evaluate your invoice payment terms to determine if they should be shortened so you can receive payments in a more timely manner. You can also improve your rates of on-time payments by offering early payment discounts or late fees. Having a system in place for following up on unpaid invoices (such as email reminders) will also streamline this process.

### 3. Optimize Inventory Management

Investing in inventory management solutions can help your business increase inventory turnover, prevent excess stockpiling of unsold goods, and address other inventory-related concerns. With inventory management software, you can reduce DIO and improve overall profitability. Consistently tracking sales will help you optimize pricing, production, vendor relationships, and other activities that directly impact your bottom line.

### 4. Utilize Invoice Factoring

Invoice factoring is a noteworthy form of working capital financing because it doesn’t require that your business go into debt with a typical loan. Instead, invoice factoring allows you to sell unpaid invoices to a factoring company in exchange for a cash advance. Your business typically receives 80-90% of the value of the invoice upfront. After the factoring company collects payment from your clients, they will provide the rest of the value of the invoice, minus their factoring fee.

With invoice factoring, you can get fast funding without affecting your business’s credit or ownership stake. Businesses that struggle to collect payments from clients can benefit from this option to turn accounts receivable into more liquid assets.

## Working Capital Metrics FAQs

### Is working capital a measure of liquidity?

Yes, working capital is a measurement of a company’s liquidity—or whether it has enough cash and current assets to cover its current liabilities.

### What is the difference between working capital and liquidity?

Working capital specifically measures the funds a company has available to support its current activities. This helps businesses evaluate their liquidity, or their ability to cover short-term financial obligations within the current financial year.

### What formula can you use to measure a company’s working capital?

To calculate your company’s working capital, take the total of your current assets, then subtract your total current liabilities.

Working Capital = Current Assets – Current Liabilities

### What is a good working capital ratio?

A working capital ratio between 1.5 and 2.0 is considered a good ratio for most companies. You can determine your working capital ratio by dividing your current assets by your current liabilities.