Working capital is an important indicator of a company’s liquidity and financial health. It’s essential for business owners to know how to calculate and interpret this metric.
In this blog, we’ll break down the concept of working capital, explore its significance in assessing a company’s finances, and provide the formulas you need to calculate it.
Working Capital Formulas
Generally, working capital is calculated by subtracting total current liabilities from total current assets. However, there are variations on working capital and how it’s calculated.
Net Working Capital Formula
Current Assets – Current Liabilities = Net Working Capital
The net working capital calculation is fairly simple. Just subtract current liabilities from current assets to determine the available capital.
Operating Working Capital Formula
Current Operating Assets – Current Operating Liabilities = Operating Working Capital
The operating working capital formula considers only the operating assets and liabilities, excluding cash and short-term debt. This approach provides a clearer picture of the funds needed to run core business operations.
Working Capital Requirement Formula
Inventory + Accounts Receivable – Accounts Payable = Working Capital Requirement
The working capital requirement formula focuses on the components that directly impact the company’s operating cycle — inventory, accounts receivable, and accounts payable. This calculation is used to determine if a business can afford manufacturing materials or inventory to sell.
Working Capital Ratio Formula
Current Assets / Current Liabilities = Working Capital Ratio
The working capital ratio formula measures a company’s short-term liquidity. This type of financial ratio is also called a current ratio. A ratio greater than 1 indicates positive working capital, while a ratio below 1 suggests negative working capital.
What Is Working Capital?
Working capital is a financial metric. It shows how much cash and liquid assets a company has available for covering day-to-day expenses and short-term debts.
To calculate working capital, you’ll need to understand your business’s current assets and current liabilities. If you’ve ever created a balance sheet for your business, you may be familiar with assets and liabilities. “Current” refers to one year or one business cycle (whichever is shorter).
Current assets are anything owned by the company and can be converted into cash (liquidated) or used within a year. These can include:
- Cash and cash equivalents
- Marketable securities (short-term investments such as stocks, bonds and mutual funds)
- Accounts receivable (money owed by customers)
- Raw materials
- Prepaid expenses
Long-term investments, such as real estate, are not considered current assets because they cannot be liquidated quickly.
Current liabilities are the company’s obligations or debts that are due within a year. These can include:
- Accounts payable (money owed to suppliers, vendors, utilities, etc.)
- Short-term loans
- Dividends for investors
- Income taxes
- Other short-term debt repayments
Why Is Working Capital Important?
Working capital acts as a measure of a company’s ability to meet its short-term obligations and invest in growth opportunities. It ensures smooth day-to-day operations and can influence a company’s creditworthiness and financial stability.
Working capital is essentially the money a company has for everyday needs. It’s vital because it helps them pay their bills, buy things they need to sell, and handle unexpected situations. If a company has enough working capital, it can usually run smoothly, keep its suppliers and customers happy, and grow. But if it doesn’t have enough, it can face financial troubles and might struggle to stay in business. Sufficient working capital can also help businesses — especially those with seasonal fluctuations — withstand slow periods. So, it’s essential for companies to take working capital management seriously.
What Is a Good Working Capital Ratio?
A good working capital ratio generally falls between 1.2 to 2.0. This range indicates that the company has enough current assets to cover its short-term liabilities comfortably. If a company’s working capital ratio is less than 1, it could indicate cash flow problems — not enough cash to cover future expenses. If a company’s working capital ratio is too high, it could indicate that the company is sitting on capital instead of using it to grow their business.
Positive Working Capital vs. Negative Working Capital
Positive working capital means that a company’s current assets exceed its current liabilities, allowing it to pay off short-term debts and invest in growth. Negative working capital indicates that the company may struggle to meet its short-term obligations using current assets alone.
What If I Have Negative Working Capital?
Having negative working capital is not always alarming, especially for certain industries with extended payment terms (such as subscriptions or long-term contracts) or cash-up-front businesses (such as restaurants, retailers and grocers). However, consistent negative working capital may lead to cash flow issues and hinder growth.
Small business lenders may help you cover financial obligations until you can improve your working capital ratio. You may want to consider a small business term loan or open a business line of credit if you have liabilities that need to be paid.
Should I Track the Change in Working Capital?
Yes, tracking the change in working capital over time is crucial. A declining trend in working capital may indicate potential financial distress, while a consistently positive trend demonstrates a healthy and sustainable financial position.