Duncan Ferris
The basic definition of working capital, also known as net working capital, is that it is a business’s current assets minus its current liabilities. It is a metric used to measure short-term liquidity and financial health, as it offers business owners an insight into how well equipped their company is to face upcoming obligations.
Below, we’ll explore the formula to calculate working capital, explain why it’s important for your business and detail some key ways in which you can manage your business’s working capital.
How to calculate your working capital
Working capital formula
The formula for calculating working capital is simple and easy to understand:
Working capital = current assets – current liabilities
Of course, it is essential to understand what needs to be included in this formula in order to use it properly. So let’s dig into the terminology.
Understanding assets and liabilities
The term current assets refers to items that will be sold or otherwise converted into cash within the next year. As such, it can include the likes of:
- cash and cash equivalents
- accounts receivable
- notes receivable
- inventory
- marketable securities
- prepaid expenses
- other liquid assets
Meanwhile, the term current liabilities is a mirror image. It refers to financial obligations that are to be fulfilled within the next year. So, current liabilities can be:
- accounts payable
- short-term debt
- un-earned revenue (pre-sold or pre-ordered goods or services)
- wages
- income tax and VAT
- accrued expenses
Working capital example
Below is an example of how a business can calculate its working capital.
Business X has cash and cash equivalents of £20,000, inventory worth £5,000 and accounts receivable of £2,500. The company has total current assets of £27,500.
For the next year, Business X’s financial obligations are comprised of wages worth £12,000, taxes worth £4,000 and short-term debts of £1,500. This means Business X has current liabilities of £17,500.
The company’s total current assets (£27,500) minus its current liabilities (£17,500) come to £10,000. As such, Business X has working capital of £10,000.
Why is working capital important?
Now we understand how to use the formula for working capital, it’s important to establish why working capital is important. Simply put, working capital is what keeps a business afloat, as it allows for the purchase of goods and services, paying staff and paying off debts.
Understanding working capital and the calculations surrounding it are just as essential.
That’s because they offer you insight into whether your business is equipped to meet its short-term obligations, and whether the company has sufficient excess capital to invest in expansion.
Crucially, third parties are often interested in the state of a business’s working capital too. Strong working capital makes a business look like a much more engaging proposition to lenders, investors and suppliers who you might be trying to attract. Being in good financial health sends positive signals.
But there are also ways to use working capital to examine the state of your business’s finances in even more detail.
What is a working capital ratio?
Your company’s working capital ratio, also known as the current ratio, is another important calculation to be aware of. The ratio allows a business to work out how many times over they could pay off their current liabilities with their current resources.
To calculate the ratio, you simply divide current assets by current liabilities rather than subtracting one from the other.
Working capital ratio = current assets / current liabilities
As such, the earlier example of Business X would have a working capital ratio of £27,500 divided by £17,500, which equals 1.57.
A working capital ratio of less than one is generally considered to be an indicator of financial insecurity, as it suggests a business will have trouble paying for upcoming expenses. Meanwhile, a ratio of more than two could mean a business is holding on to too much money when it could invest in growth or improvement.
Business X’s ratio of 1.57 is in the sweet spot, which is broadly agreed to be between 1.2 and 2.
» MORE: How to grow your business
How to manage working capital
Calculating your business’s working capital and working capital ratio is important, but it is also key to understand how to manage your capital.
It doesn’t matter how successful your business is if you don’t have enough cash to satisfy short-term obligations.
A proactive approach can ensure that your business is making the most efficient use of both its assets and its liabilities. This will allow a business to maintain a healthy working capital ratio over an extended period, creating long-term financial health and allowing a business to avoid running into trouble.
One crucial aspect of managing working capital is making the distinction between certain assets. While calculating working capital involves lumping all current assets together, it is worth considering how different assets’ liquidity varies.
For example, a business’s inventory (the goods and products you sell and the raw materials you have in stock) is a current asset, but what if consumer demand is not as strong as expected? The asset’s value is reliant on it selling for unit price, but it could sell at a lower value or fail to sell at all.
In short, inventory can be a risky asset to be overly reliant on as its conversion into cash is outside a business’s control. The good news is that a business can balance this risk with assets and liabilities it can control to better manage working capital.
For example, a business can decide when and how it pays for goods and services, as well as what proportion of cash to keep on hand. Make sure you use your assets AND liabilities wisely, so your business isn’t caught short.
Another useful way to gain insight into your business’s working capital is the working capital cycle.
The working capital cycle
To have a complete grasp of your working capital management, determining your working capital cycle can be useful. This is essentially a measure of how long it takes for your working capital to be translated into cash.
The formula for calculating your working capital cycle is:
Working capital cycle = Inventory days + Receivables days – Payables days
- Payables days: How long your business has to pay for the raw materials from which it makes its products.
- Inventory days: The average length of time it takes for raw materials to be transformed into your finished product and sold.
- Receivables days: The number of days it normally takes for your customers to pay.
A shorter cycle is generally viewed as most desirable, as it limits the amount of time in which working capital is inaccessible as cash.
Businesses can shorten the length of this cycle by taking measures, such as operating on a cash-only basis, chasing payments more aggressively or optimising manufacturing timelines.
If you need further help managing your working capital, it might be a good idea to contact a qualified accountant.
Image source: Getty Images
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