8 min read
8 Sep 2023
8 min read
8 Sep 2023
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.
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 are liquid assets that are easily converted to cash; these include:
Current liabilities are comprised of monetary sums owed as well as obligations to remit goods or services within the year. As such, they include:
The formula to calculate working capital (or the working capital formula) is as follows:
Current assets – Current liabilities = 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.
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
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.
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
Whichever method a company uses when calculating working capital, the result will indicate whether the business’ working capital position is positive or negative.
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.
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:
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