Working capital ratio: what’s healthy for a SaaS business?

The working capital ratio measures a company’s short-term financial health and operational efficiency. This ratio has close ties to working capital, a metric found by subtracting a business’s current liabilities from its current assets.

By paying attention to your company’s working capital ratio (or the “current ratio”), you can gain insight into its financial situation and make informed decisions about its future. Read on for a closer look at this metric and tips on how to tell if your SaaS business’s ratio is where it needs to be.

Calculating the working capital ratio

To calculate your company’s working capital ratio, use this simple formula:

Working capital ratio = current assets/current liabilities

This ratio indicates your company’s ability to cover short-term obligations using its liquid assets. A higher ratio generally reflects a stronger liquidity position. This will also help you determine how much money you can afford to use while pursuing capital investment, expansion plans or other opportunities.

What is an ideal working capital ratio?

An optimal working capital ratio is typically between 1.5 and 2. If your working capital ratio is within this range, your company has enough money on hand to cover supplies, salaries and other obligations without running into trouble.

On the other hand, a ratio in excess of 3 should serve as a red flag. That means your company may not be doing as much as it could to drive future growth with its assets. If your ratio is that high, it’s time to explore potential new markets, invest in R&D or look for additional opportunities to compete with other SaaS businesses.

In SaaS, current liabilities often include large deferred revenue balances from prepaid subscriptions, which aren’t true cash liabilities but do affect the working capital ratio. This makes interpreting the ratio more nuanced for SaaS finance leaders.

What does a negative working capital ratio mean?

An overly high working capital ratio isn’t the only problem you can find after completing this formula. A working capital ratio below 1 indicates that your company has less in current assets than current liabilities. This signals a liquidity risk.

When you’re in this situation, you’ll want to focus on avoiding liquidity issues and start exploring ways to increase revenues and/or reduce expenses. Additionally, you’re probably exposed to one or more of the following risks:

• Trouble meeting payroll and debt obligations. Without more working capital, unforeseen expenses could jeopardize basic operations. 
• Supplier risks. You may not be able to maintain your current supply chain network.
• Missed growth opportunities. A lack of available finances may impact your ability to capitalize on emerging opportunities. 
• Operational inefficiency. Your business may be over-reliant on manual workflows that increase errors, consume resources and inflate payrolls. 

Working capital loans: what you need to know

How is your working capital ratio impacting your business goals? Are you dealing with an especially tight shortfall, or do you need to finance a crucial growth project? If so, it may be time to think about increasing your working capital by taking out a working capital loan.

Working capital loans, which can help increase a business’s working capital when it plans to pursue growth projects or faces cash shortfalls, are usually amortized over four to eight years. Financial institutions consider a company’s previous and forecasted cash flow when deciding whether to grant these loans.

Your business might be a good fit for a working capital loan if:

• Its biggest customers are taking longer than usual to pay invoices
• It has a strong cash flow history, but is about to hit the limit of its credit line
• It needs to purchase inventory due to an unexpected rise in demand
• It is growing rapidly/developing a new product, but won’t be able to recoup its investment cost with sales growth for a while
• It aims to utilize supplier volume discounts (but doesn’t want to affect cash flow)

How tax credits help SaaS companies access working capital

R&D is a significant expense for SaaS companies – some businesses in this industry allocate up to 30% of their revenue to this work. With that in mind, the federal research and development tax credit can go a long way for SaaS businesses. While the R&D tax credit doesn’t directly increase working capital, it reduces your federal tax burden, freeing up more internal cash for operating or growth initiatives.

To be eligible for the credit, a business’s R&D initiatives must:

• Have the right purpose. You’ll need to work on either developing new business components (such as products, processes or software) or enhancing existing components for this credit to be applicable.
• Deal with technology. Your research must focus on fields such as computer science, engineering, physics, biology or chemistry.
• Focus on experimentation. As part of your R&D work, you’ll have to incorporate experimental practices like testing, trial and error or exploring alternatives.
• Aim to eliminate uncertainty. Finally, your efforts must aim to resolve uncertainties your business faces.

While the R&D tax credit can give your SaaS company an opportunity to use capital for growth, you’ll need in-depth documentation to claim this tax credit. This strategy also works best for large, profitable SaaS businesses. If you’re a finance leader for a startup with low taxable income, another method of unlocking working capital may deliver better results.

Other steps you can take to improve your ratio

Looking for more ways to enhance your working capital ratio? As part of your efforts to accomplish this goal, you can:

• Shorten your operating cycle. If you need to pay suppliers before handling payroll, you might have to use your accounts receivable as collateral to fund a working capital increase. Adopting a shorter operating cycle can help you avoid this issue.
• Streamline billing and AR. If these departments are getting buried under manual work, they’re likely facing a host of inefficiencies contributing to capital shortfalls. 
• Invest in trade credit insurance. This type of insurance can help companies stabilize their working capital ratios. Since it is considered secured collateral, trade credit insurance can also make it easier for SaaS businesses to get outside financing.
• Explore tax credits. A working capital tax credit may be available for R&D or digital transformation.

Considering automation solutions

Although a tight working capital margin may make investments more difficult, it often indicates a vicious cycle of inefficient manual workflows. If your finance strategy is only partially embedded in your ERP or worse, exists wholly outside it, you are likely facing the following:

• High payroll and operational costs. Without a vertically integrated tech stack, employees will have to stitch your systems together with spreadsheets and hours of manual reconciliation. 
• Extended timelines. Month-end closes can often take weeks instead of days without ERP-embedded finance strategies. 
• High error rates. Data entry issues associated with non-automated strategies filter across the business, inflating costs from billing to reporting to compliance. 

Take NetSuite even further with Zone’s SuiteApps

NetSuite users benefit from powerful finance software for optimizing cash flow with true ERP-embedded finance – not just basic automation. If you need help monitoring your SaaS company’s working capital ratio and other financial statistics, Zone & Co’s SuiteApps will deliver the capabilities you’re looking for. 

By adding applications like ZonePayroll, ZoneCapture and ZoneReconcile to your ERP, you’ll unlock a 50% increase in payroll processing speed, 90%+ fewer AP data entry errors, 100% compatibility with financial data integrations and many other advantages. Find out more about Zone’s SuiteApps by setting up a demo today,

“ZoneBilling and ZonePayments have been a game-changer for us. They streamlined our processes, reduced manual work, and provided the scalability we needed to support our growth. Our billing system no longer constrains us.” – Lakshman Manoharan, Head of Business Systems at Lattice