It takes strategical planning, critical thinking, dedication, time, and monetary investment to set up a business and then take it towards success. Whether it is a low investment business or a large-scale business, every business owner has to invest time and money into stabilizing their setup. Before one set foot in the corporate sector, it is crucial for them to strengthen their concepts about several business and finance terms. Many people step into the business world without clarifying their concepts which leads them to wrong decisions and incorrect moves. It can lay the grounds for disastrous results. Therefore, if you are planning to start your business, make sure you understand the essential terms.
The first two terms that you need to have a clear understanding of our scalability and resiliency. As business owners, the primary focus is scalability, which revolves around the growth of a business. It is a term that is used to describe a business’s growth or contraction. However, many business owners do not consider resiliency and half of them are not even aware of this term. Resiliency is the characteristic of a business to respond to a problem and return to its original state. The elements that affect both scalability and resiliency of business includes working capital ratio and cash flow. Yes, these are two different terms that you cannot use interchangeably. Both revolve around a company’s finances.
Understanding the Difference between Working Capital Ratio and Cash Flows:
So, what is the difference between working capital ratio and cash flow? Well, before we talk about the working capital ratio, we need to understand what working capital is and how it affects a business. Working capital is the difference between a company’s current assets and current liabilities. It is the amount of money a company has to handle its short-term expenses. It is absolutely necessary for businesses to maintain a proper working capital. If a company hits a setback, working capital ensures that the company’s day to day operations and processes are run smoothly, without interruption. It is due to this reason fastcapital360 working capital loans are beneficial for all types of businesses. It provides a company with an ability to meet its present financial obligations and remain stable.
The working capital ratio is equal to the current assets divided by current liabilities. An ideal working capital is 2:1. Things get complicated for businesses when the ratio drops to 1:1. It is the borderline, and after this, a company has to improve its working capital as it has gone negative. Higher working capital is not beneficial for a business. In such a case, a business is leaving too much money unused, which it can invest in their business.
Now, coming to cash flow. How cash is flow different form a working capital ratio? The cash flow of a business is total cash or cash-equivalent that moves in and out of a company. There are two types of cash flows, including positive cash flow and negative cash flow. Positive cash flow indicates an increase in a company’s liquid assets. Negative cash flow indicates that a company does not have enough cash to manage the daily operations of a company.
Link between Working Capital Ratio and Cash Flow:
Yes, both working capital ratio and cash flow are two different terms, but one can be used to describe the other. The working capital ratio can tell a lot about a company’s cash flow. The impact of changes in your company’s working capital is visible in your company’s cash flow statement. Whether the ratio increases or decreases, it will impact the cash flow.
It is essential to understand that not all financial transactions have an impact on the working capital but can impact the cash flow. There are some transactions that increase the current assets as well as current liabilities. In this case, there is no change in the working capital, but it does increase the cash flow. One such scenario is a company receiving a short-term debt that has to be paid in 60 days. The amount received as a loan will add to the current assets, and the amount payable will add to the current liabilities.
Other forms of cases that a business owner may find themselves into is the sale of a fixed asset. When a company sells its fixed asset, it can boost both its working capital as well as cash flow. When a firm purchases a fixed asset, both the working capital ratio, as well as the cash flow, will decrease. The purchase will reduce the cash portion of the current assets but will not change the current liabilities.
Working Capital Ratio of 2:1
A high working capital ratio indicates a positive cash flow of a company. It shows that the amount a company is earning is higher than the amount it is spending on addressing the current liabilities. If a company’s working capital ratio is 2:1, it means that the company’s cash flow is in its ideal state. A firm is saving half of its earned amount that it can use to pay off debts, keep the operations running, and invest back into the business.
Working Capital Ratio Higher than 2:1
The second case is where a company operates with a working capital ratio higher than 2:1. It might seem like a good thing to business owners, but it really is not. A working capital ratio that exceeds 2:1 means that a business is underusing its assets and not investing in the business. For a business to grow, it is essential to invest in it. A high working capital ratio indicates that a business needs to increase its outward cash flow. It has to use the gathered amount to reinvest into the business. A company’s cash flow is not ideal in this case, and the amount flowing in is much higher than the amount flowing out.
Working Capital Ratio 1:1
Just like a working capital ratio too high is not beneficial for a business; a working capital ratio too low is also not the ideal situation. In this situation, a business’s working capital is negative, which means the money flowing out is much higher than the money flowing in. It is a situation of high alert for all business owners. It is an indication that a business has to work on increasing its inward cash flow.
If you wish to run your business successfully, it is vital that you develop a full understanding of the common terms. There are significant factors of differences between a working capital ratio and the cash flow of a company, but both these have a deep connection with each other. The working capital changes are clearly visible in a company’s cash flow statement. The working capital ratio helps a business revamp its strategy to address its financial obstacles and hurdles. Remember that a working capital ratio equal to or close 2:1 is the ideal figure. You need to focus on achieving it. Maintaining an ideal ratio will give you peace of mind. If your business experiences a significant loss, it will have cash at the backend to support the daily operations of the company.