10 Ways To Improve Your Working Capital Ratio & Liquidity
You’ve probably come across the term before but may not have given it much thought. Working capital is a concept that is used, in broad strokes, to get a sense of the health of a business.
Working capital compares your current assets against your current liabilities. Your working capital is determined by subtracting your current liabilities from your current assets. You want this number to be positive. Your working capital ratio is determined by dividing your current assets by your current liabilities. Ideally, you want this number to be somewhere between 1.2 and 2. If it’s lower, you may not be able to handle an unexpected expense. If it’s higher, you may not be reinvesting your capital efficiently.
Below we’ll look at some ways on how to improve your working capital ratio.
Table of Contents
- 1) Retire Outstanding Debts
- 2) Refinance At Lower Interest Rates
- 3) Manage Inventory More Efficiently
- 4) Identify Unnecessary Expenses
- 5) Collect Your Invoice Payments On Time
- 6) Make Sure You’re Getting Good Deals
- 7) Make More Sales
- 8) Put Your Money To Work
- 9) Take Advantage Of State & Local Programs
- 10) Get A Working Capital Loan
- Final Thoughts
1) Retire Outstanding Debts
One of the more obvious ways to improve your working capital ratio if it’s under 1.2 is to chip away at your current liabilities. One of the easier ways to do that is to pay off liabilities that do little beyond adding interest payments to your cost of doing business.
Ideally, you’ll want to get ahead of your debt payments. You should especially take care to avoid carrying a credit card balance month to month if you can help it. If you’re unable to do so, you should at least make sure that you’re not losing money to unnecessary late fees. If you’re missing payments and being penalized for it, consider automating as much of the process as you safely can, given your company’s cash flow.
2) Refinance At Lower Interest Rates
If interest rates have been causing your liabilities to skyrocket, the best option is to pay them off. If you’re unable to, the next best option is to look into reducing the amount of interest you’re paying. Interest rates, after all, may fluctuate with the market, your credit score, type of financial product, promotions, or perhaps the whim of the fates.
Refinancing can take the form of a loan with a lower interest rate or a credit card with a limited 0% interest APR. You may even be encouraged to transfer an existing balance. Just always be sure to read the fine print to verify that you’re getting the deal you think you are. Be especially wary of double-dipping if you’re looking at short-term loans or merchant cash advances.
3) Manage Inventory More Efficiently
Improving your working capital isn’t just a matter of managing debts. You can also increase the efficiency of your business and improve your working capital ratio by making sure your inventory is moving efficiently.
Remember that your current assets are based on your liquidity and assets that will soon become liquid. Inventory that isn’t moving may be racking up storage costs, but even if your storage costs are minimal, there’s another problem. Your liquidity is tied up in storage.
Planning your inventory so that it moves quickly will increase your working capital ratio. Consider auditing your supply processes so that you’re limiting the amount of time that any item is collecting dust on your shelves. You may also want to invest in new inventory management software.
4) Identify Unnecessary Expenses
Remember that the higher your liabilities are, the lower your working capital ratio will be. Any cut to your liabilities will improve your ratio so long as your current assets remain static or increase. That second part is very important because reckless budget cuts can have negative effects on your working capital.
Take a close look at your budget and get a sense of which are core to the functioning of your company and which ones aren’t necessarily contributing to your revenue. Are you spending too much on energy? Transportation costs? Are you able to time your expenses to your income more effectively so that you’re not taking on as much debt?
While none of these things may add up to enormous savings on their own, in aggregate, they may have a noticeable impact on your working capital ratio.
5) Collect Your Invoice Payments On Time
Your invoices may represent a customer’s promise to pay, but sometimes they can go unpaid for an unacceptably long time. Invoices that are going unpaid may be counted toward your current assets, but that doesn’t do you much good if they never turn into liquidity.
So how can you get your payments on time? One way is to incentivize repayment. You can take either a carrot or a stick approach to this. For example, you can offer future discounts or perks to customers that pay their invoices on time. Alternatively, you can charge late fees for overdue invoices. You may want to experiment with policies to see which ones your customers respond to. You can even try some combination of the two.
6) Make Sure You’re Getting Good Deals
There are times we become slaves to inertia and keep doing the behaviors we developed years ago. Case in point, some people still use Internet Explorer. You don’t want to make this mistake with vendors by assuming you’re still getting a good rate years after you started using them.
If you haven’t checked prices on your supplies in a while, take the time to look at your expenses, compare market prices, and see if you’re getting your money’s worth. Even if you don’t switch suppliers, you may be able to use the information you research to negotiate a better rate.
7) Make More Sales
Cutting costs can be difficult and depressing. The good news is you don’t necessarily have to reduce your liabilities to increase your working capital ratio. You can instead increase the amount of revenue coming into your company.
It may sound like a no-brainer, but moving more products or services will increase your company’s health. However, doing so may mean that you need to add some costs in the form of additional staff, advertising, or even investments in software or equipment. Consider your ROI, and don’t be afraid to try to reach new markets.
8) Put Your Money To Work
So far, we’ve mostly covered how to increase your working capital ratio, but what if you need to lower it? Remember, a working capital ratio that’s over 2.0 may indicate that you’re not reinvesting enough of your assets into your company.
If your working capital ratio is high, think about how you could use some of that liquidity to grow (assuming you want to, of course). Do you need more staff? Do you have old equipment that needs an upgrade? Renovations to modernize your facility? All of these can pay off down the road.
9) Take Advantage Of State & Local Programs
You may have made it this far in your business without tapping any state programs, but you may be leaving money on the table.
State and local governments have an incentive to grow and sustain their business communities. If you need a little extra liquidity, take some time to look at any grant programs offered to your industry or area.
10) Get A Working Capital Loan
Finally, you can increase the amount of working capital you have to work with by getting a working capital loan. These are flexible loans that can be used for a variety of operational expenses. Keep your liabilities in mind as you take on debt, or your temporary burst of working capital may drag your working capital ratio down in the medium to long term.
Need some help finding a quality working capital loan? Check out our best working capital loans for 2021.
By now, you probably have a sense of how your working capital ratio is a rough estimate of your company’s health and that it’s something you can affect in any number of different ways.
For more information on working capital, check out our article: What Is Working Capital & Why Is It Important For My Small Business?