Bookkeeping · Financial Statements · Brief · Working level
Working capital basics: the current ratio and the cash conversion idea
Working capital is current assets minus current liabilities — the cushion that pays next month's bills. What the current ratio tells you, and how the cash conversion cycle explains why growing businesses feel broke.
Working capital is current assets minus current liabilities — the balance sheet's answer to "can this business pay its bills for the next few months?" The current ratio expresses the same comparison as a quotient (current assets ÷ current liabilities), and the cash conversion cycle explains the dynamics: how many days each dollar stays trapped between being spent and coming back as collected revenue.
The current ratio, computed
Take the balance sheet from the balance sheet, explained: current assets of $53,000 against current liabilities of $23,100 gives a current ratio of 2.3 — each near-term dollar owed is covered 2.3 times. Interpretation rules:
- Above 1.5: comfortable at small scale.
- 1.0–1.2: watch monthly; one slow collections cycle from trouble.
- Below 1.0: near-term obligations exceed near-term resources — arrange financing or accelerate collections now, not after a miss.
Composition beats the headline number. Subtract inventory from current assets and re-divide (the "quick ratio") to see coverage from assets that are already money or nearly so. A ratio propped up by slow-moving inventory or aged receivables is weaker than it prints.
The cash conversion cycle, in plain terms
Every business fronts money before earning it back: buy materials, do the work, invoice, wait. The cash conversion cycle counts the days:
Days your cash is trapped = inventory days + receivable days − payable days.
| Component | Meaning | Illustrative shop |
|---|---|---|
| Inventory days | How long stock sits before selling | 40 |
| Receivable days | How long customers take to pay | 35 |
| Payable days | How long you take to pay suppliers | (25) |
| Cash conversion cycle | Days each dollar is fronted | 50 |
Fifty days means the business finances nearly two months of its own activity continuously. Now double revenue: the trapped amount roughly doubles too — which is why growth makes profitable businesses feel broke, the mechanism worked numerically in the cash flow statement guide.
Shortening any component frees permanent cash: deposits and progress billing cut receivable days; leaner ordering cuts inventory days; negotiated supplier terms extend payable days. A five-day improvement at $10,000 of daily costs is $50,000 of cash that never needs borrowing — the arithmetic behind most working-capital lines of credit, which the SBA covers on the financing side.
Track two numbers monthly — the current ratio and receivable days — as part of the routine in the monthly reporting package; the broader ratio set is in financial ratios worth a small operator's time.
Frequently asked questions
- What is working capital and how is it calculated?
- Working capital is current assets (cash, receivables, inventory) minus current liabilities (payables, credit cards, taxes due, loan principal due within a year). Both figures come straight off the balance sheet. Positive working capital means near-term resources exceed near-term obligations; the current ratio expresses the same idea as a ratio rather than a difference.
- What is a good current ratio for a small business?
- As a rule of thumb, comfortably above 1.5 — current assets covering current liabilities one and a half times. Below 1.2 deserves attention, and below 1.0 means near-term obligations exceed near-term resources. But composition matters: a 2.0 ratio built mostly of stale inventory and 90-day receivables is weaker than a lean 1.5 built of cash.
- What is the cash conversion cycle in plain terms?
- The number of days between paying for inventory or labor and collecting cash from the sale it produces. Days of inventory plus days of receivables, minus the days your suppliers wait to be paid. Every day of the cycle must be financed by someone — which is why fast-growing businesses with long cycles feel permanently short of cash.