In the first two columns of this series, I defined working capital, reviewed its underlying components and analyzed some of the factors affecting the rate at which it cycles through your business. I also mentioned some ways in which you can manage it more efficiently and reduce its cycle time, generating greater liquidity and more available cash. This month, I review the key ratios you can use to measure how successfully your company uses working capital. Some of the ratios will be familiar to you if you regularly analyze your financial statements. Below, I use the same balance sheet numbers from the table in the February column for a company showing sales revenue of $2 million on its income statement.


Working capital ratio


The overall working capital ratio is the total of inventory, accounts receivable and accounts payable as a percentage of sales revenue:



($50,000 + $500,000 + $300,000) / $2,000,000
 = 42.5%


A higher percentage indicates a greater need for working capital relative to your level of sales. The components of this ratio should also be analyzed. These include the current, quick, stock turnover, accounts receivable and accounts payable ratios.


Liquidity ratios—
current and quick


It’s essential to consider the most common measures of liquidity. The current ratio divides current assets (which can be turned into cash within 12 months) by current liabilities (which must be paid within 12 months):


$750,000 / $600,000
 = 1.25


This measure of 1.25 times means that you should expect to have $1.25 in cash available to pay each $1 that is due to creditors. Anything over 1.00 is acceptable, but healthy companies strive for 2.00.


The quick ratio accounts for the time needed to convert inventory into cash and subtracts the inventory number ($50,000) from current assets ($750,000) divided by current liabilities:


$700,000 / $600,000
 = 1.17


Since inventory levels are relatively low for most electrical contractors, the quick and current ratios will probably be similar, unless your company does substantial maintenance work.


Inventory turnover


The stock turnover ratio calculates the average number of days it takes to use your inventory, dividing average stock times 365 (days in a year) by your cost of goods sold (CGS). If the CGS from this sample income statement is $1 million and the $50,000 inventory number is also the average stock, it takes roughly 18 days to fully use your stock of materials:



($50,000 × 365) / $1,000,000 = 18.25



If this number reaches 120–180 days, a breakdown of materials in stock will clarify whether you have obsolete material that will never be used on a project, slow-moving items lingering in the warehouse, or errors in your ordering process. On the other hand, you might have deliberately purchased bulk items for a substantial discount. In this case, a higher turnover number may be offset by your cash savings.


Payables and receivables


Effectively managing accounts payable and accounts receivable is also essential to an efficient working capital cycle. The receivables ratio measures the average number of days it takes to collect on your invoices, dividing accounts receivable times 365 (days in a year) by sales revenue:



($500,000 × 365) / $2,000,000
 = 91.25


If this company’s invoice terms are net 30 days and its average collection time is more than triple that time frame, it needs to either extend its terms formally or upgrade its collection process.


The payables ratio substitutes the accounts payable number for accounts receivable and uses CGS instead of sales revenue:



($300,000 × 365) / $1,000,000
 = 109.50


The good news for this company is that it has shifted the effect of its inability to collect per its invoice terms to its suppliers and, surprisingly, has 18 days of cushion. The bad news is that its suppliers are probably unhappy with the situation and will raise prices or tighten terms if this practice continues.


Other measures of working capital may include bad debts as a percentage of sales, the costs of loans and lines of credit, and discounts for early payment of your invoices. You should also be aware of “debtor concentration,” which measures your dependence on a limited number of customers for most of your revenue. 


Regardless of what the individual ratios indicate, managing working capital is a continual process that requires awareness of the individual components and their effect on the overall picture. Each ratio should also be compared to the norms within the electrical contracting industry, and its trend should be tracked over time. You should remain vigilant about the effect of inventory levels, payment terms and collections. The goal is always to smooth out the flow of cash through your company, creating enough liquidity to protect its financial health during difficult times and provide investment opportunities during good ones.