How to calculate working capital

Working capital is essential for the day-to-day operations of a company. It’s used by businesses for all sorts of things, from paying wages to investing in growth. But it’s also a key indicator of short-term financial and operational health.

Here’s everything you need to know about how to calculate working capital and why it’s so important to stay on top of it.

What is working capital?

Working capital represents the free capital that a business can access to pay for day-to-day operations or to fund development and growth. It’s a useful metric to measure the short-term financial health of a company.

Calculating working capital is straightforward. There are just two components to the calculation, and both are listed on a company’s balance sheet. In a nutshell, working capital is the value of the business’s current assets after current liabilities have been subtracted.

Assets are classed as current when their value is expected to be converted into cash within a year. Similarly, current liabilities are a company’s short-term financial obligations that are due to be settled during the same period.

Here’s a little more about the two components used in the working capital calculation:

Current assets

Current assets are liquid assets that are easily converted to cash; these include:

• Cash and cash equivalents: Includes certificates of deposit, money market funds, short-term government bonds, and treasury bills.
• Accounts receivable (AR): This represents the value of goods or services delivered but not yet paid for by customers.
• Inventory: This includes raw materials, components, work-in-process, finished products, and packaging.
• Prepaid expenses: These are recorded as assets because they represent a future benefit to the business. Examples include insurance premiums, prepaid rent, and retainers for legal services.

Current liabilities

Current liabilities are comprised of monetary sums owed as well as obligations to remit goods or services within the year. As such, they include:

• Accounts payable (AP): Money owed to vendors and suppliers for goods, raw materials, and other operating expenses
• Bank overdrafts, short-term loans, and short-term payments related to long-term debts
• Employee wages payable
• Accrued tax payments owed within the next 12 months

Working capital formula

The formula to calculate working capital (or the working capital formula) is as follows:

Current assets – Current liabilities = Working capital

How to calculate working capital

Companies can use the working capital formula to calculate their current working capital position. In other words, the figure reached from the working capital formula represents how much capital they have to spend on day-to-day operations.

As their current assets and liabilities continue to change, so will the working capital of the business. When current assets exceed current liabilities, the working capital figure generated will be positive. When current liabilities exceed current assets, the business is described as having negative working capital.

Working capital formula – example

A company’s balance sheet records $10 million of current assets, while its current liabilities are shown as $8 million. Its working capital is, therefore, $2 million.

$10 million – $8 million = $2 million

The working capital ratio

An alternative way of looking at working capital is the working capital ratio, which shows a business’s current assets as a proportion of its liabilities rather than as an integer. The working capital ratio is calculated by dividing all current assets by current liabilities. The formula is:

Current assets / Current liabilities = Working capital ratio

The business has net positive working capital if the ratio is 1 or above. If the ratio is below 1, the business has net negative working capital.

Working capital ratio formula – example

A company has $10 million of current assets, while its current liabilities are $8 million. Its working capital ratio is, therefore, 1.25.

$10 million / $8 million = 1.25

Positive vs. negative working capital

Whichever method a company uses when calculating working capital, the result will indicate whether the business’ working capital position is positive or negative.

• Positive working capital indicates that a business can theoretically pay off all its current liabilities with its current assets. The better a company’s working capital position, the more flexibility it has to expand its operations.
• When working capital is negative, the opposite is true. To cover all its liabilities, a business would need to find additional funds from elsewhere.

Generally, a higher working capital figure or ratio is seen as positive, while a lower one is seen as negative. However, in certain situations, negative working capital may not be problematic.

For example, businesses such as restaurants may have high volumes of cash sales, meaning that payment is received from customers straight away, while suppliers may not need to be paid until a later date.

In such cases, negative working capital may be an indication of efficiency rather than of financial distress.

How to improve working capital

The purpose of working capital management is to help companies make effective use of their current assets, optimize cash flow, and maximize operational efficiency.

By freeing up cash that would otherwise be trapped on balance sheets by effectively managing accounts payable, accounts receivable, inventory, and cash, companies can ensure they have sufficient fundsto cover planned and unexpected costs. They may also be able to reduce their borrowing needs, fund growth, and invest in R&D.

Companies can use the following methods to improve their working capital position:

1. Expedite accounts receivable collections: Accounts receivable only become revenue upon payment. By improving the AR process through automation, companies can minimize delays and speed up settlement.

2. Slow accounts payable outflows: Through improvements to the accounts payable process, a business can improve visibility over outstanding bills and potentially optimize working capital by slowing down settlement. Companies may also be able to negotiate better payment terms by building stronger supplier relationships.

3. Manage inventory more efficiently: A leaner approach to inventory management can preserve cash and maximize working capital. However, strategies such as just-in-time (JIT) inventory require reliable suppliers and can expose the business to greater risk.

4. Make use of working capital solutions: Companies can use solutions such as supply chain finance and accounts receivable financing to improve their working capital:
   

• Supply chain finance is set up by the buyer as a way of allowing suppliers to receive early payment of their invoices, typically at a favorable funding cost. With the buyer paying the funder on the invoice due date, both buyers and suppliers can benefit from working capital improvements.
• Accounts receivable financing acts as a line of credit backed by outstanding debt due to be received from customers. Companies can use accounts receivable financing to free up cash trapped in unpaid invoices, thereby making better use of their assets and boosting working capital.