What is working capital and how to calculate it

What is working capital and how to calculate it

Many indicators represent the health of a business. Working capital joins the ranks of income statements and balance sheets to determine the company’s financial status. The absence or lack of working capital affects its ability to invest in itself, its employees, technology, and continued growth.

What is working capital?

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Working capital, also known as net working capital, is the calculated difference between a business’s current assets such as inventory, accounts receivable, and cash and its current liabilities such as accounts payable.

Working capital is a gauge of a company’s short-term financial health. It is reflective of its ability to pay bills, short-term expenses, and debt. Positive working capital indicates that the business has enough cash to pay off its debt and still invest in it. Positive working capital is critical for any business to continue to operate and grow. Negative working capital shows the debt is higher than the cash in hand. If a business has negative working capital, the company may not be able to continue to pay bills and service its debt. They will also not be able to hire new employees or invest in their future with capital expenditure or sales and advertising investments. When a business finds itself in this position, management should review its cash flow and determine steps to correct this situation.

What is the formula to calculate working capital?

Calculating working capital is uncomplicated. The information you need is located on your balance sheet:

Current Assets – Current Liabilities = Working Capital

Current assets are defined as assets that are available to collect within the next 12 months. They are easily liquidated and can be used to pay the debt within 12 months.

  • Cash
  • Accounts receivable
  • Inventory
  • Securities

Current liabilities are defined as short-term expenses that must be paid within 12 months.

  • Taxes due
  • Accounts payable
  • Interest payments
  • Short term debt, i.e., loans
  • Payroll

Once you have gathered all this information, just do the math. Subtract your current liabilities from your current assets, and you have uncovered your working capital!

What is the working capital ratio?

The working capital ratio measures liquidity, otherwise known as the ability to make on-time payment responsibilities.

Current Assets / Current Liabilities = Working Capital Ratio

The higher the working capital ratio, the greater a company can invest in expansion and growth. The ideal ratio depends on your industry and conditions.

  • Less than 1:1 can indicate difficulty in paying bills, and often even at 1:1, conditions may be present, making it necessary to increase collections or reduce expenditures.
  • A ratio of 2:1 indicates a reasonable level of comfort to pay bills.

Understanding the working capital cycle

working capital cycle

A company’s business working capital cycle is calculated by the time it takes to collect receivables and possibly sell inventory to obtain cash. A long cycle should possess a higher working capital ratio.

For example, let’s say Karen’s Cookies has $5,500.00 in accounts receivables and $2,500.00 in accounts payable. Her net working capital value would be $3,000 ($5,500 in accounts receivables minus $2,500 in accounts payable). If Karen’s Cookies takes 60 days to collect her open accounts receivables, her working capital cycle is twice as long as it is if Karen’s takes 30 days to collect her receivables. In this case, even with a 2:1 working capital ratio, Karen would want to improve her working capital cycle.

What is working capital management?

working capital management

As we stated at the beginning of this blog, working capital is critical to every business’s health, and managing working capital can be tricky. Working capital management is a means to assist companies in maintaining sufficient cash flow in the short term. Investopedia defines working capital management; Working capital management is essentially an accounting strategy with a focus on the maintenance of a sufficient balance between a company’s current assets and liabilities. An effective working capital management system helps businesses not only cover their financial obligations but also boost their earnings.

  • Manage accounts receivable
  • Inventory management
  • Manage account payable
  • Manage short term debt
  • Liquidity management

Actively managing and monitoring these activities can ensure the resources are available for operating expenses. Business owners can free up cash to remove the need to borrow money to expand and invest in their business.

How does working capital impact my business?

It is straightforward-

Resources + Cash = successful existence

Running a business is tricky. Protecting the company from financial hardship or even liquidation requires an understanding of cash flow, operating budget, accounts receivables, and accounts payable, working capital, and other financial ratios.

Bookkeeping is the foundation of working capital. The dangers of not doing bookkeeping stretch far beyond the financial impact on your business. If you don’t do any bookkeeping, or just for the sake of argument, you do some bookkeeping; you are running your business with blinders on. The absence of a clear understanding of your business’s financial health can seriously affect working capital calculations, including decision-making regarding hiring, purchasing, and other financially related decisions.

About Expex

Expex, based in Schenectady, NY, offers convenient and innovative bookkeeping services to help your business succeed. Our application, Carly, can do everything a traditional bookkeeper does and more. This financial management program expertly delivers bill payments, bank and credit card reconciliation, and financial records consolidation. Call (518) 389-2305 today to get started, or contact us to learn more about Carly.

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resources: Investopedia.com